Weekly Chart: Gold vs. US 5Y Real Yield

We showed in many of our charts that 2017 was the year where some of the strong correlations between assets classes broke down. We showed USDJPY vs. TOPIX (here, here), Cable (here) and EURUSD (here) vs. the 2Y and 10Y interest rate differentials, and this week we chose to overlay Gold prices with 5Y US real interest rates. As we explained it in our study on Gold (here), the relationship between Gold and US [real] rates is easy to understand. The precious metal is a non interest-bearing asset, meaning that a typical investor doesn’t get any cash-flow from owning it (unlike dividends for stocks and coupons for bonds), and has usually a storage cost associated with it. Therefore, the forward curve of the ‘currency of the last resort’ (Jeffrey Currie) is usually upward sloping, in other words Gold market is in contango, with the forward price equal to the following:

Reg.PNG

Hence, if real interest rates start to rise, a rational investor would prefer to reallocate his wealth to either US Treasuries or Treasury Inflation Protected Securities (TIPS) and receive coupons rather than keeping a long position in a commodity that has a ‘negative carry’.

As you can see it on the chart, Gold prices (in US Dollars) and the 5Y TIPS real yield have shown some strong co-movements over the past 5 years, until the summer of 2017 when the two times series diverged. If we would follow recent moves on the market, the late surge in Gold prices (currently trading at 1,340 $/ounce) would imply a 50 to 60 bps decrease in US real interest rates (note that if we regress the change in Gold prices on the change in the 5Y real yield using weekly data since 2013, we find that a 1% increase in real yields lead to an 8.7% depreciation in Gold prices). And lower real rates would either come from higher inflation expectations or lower nominal interest rates. With the 5Y5Y forward inflation swap currently trading at 2.11% and up 30bps over the past 6 months, core inflation and core PCE YoY rates at 1.8% and 1.5% slightly moving to the upside, and oil prices still trending higher with WTI front month contract trading at $64.5, there is room for higher inflation prints coming ahead. However, if the two curves were to converge in the short term, the [sharp] move would come from either [lower] Gold prices or [lower] Treasury rates.

Our view is that the divergence will persist in the beginning of 2018, with inflation remaining steady / slightly increasing and US interest rates failing to break new highs on the long end of the curve (5Y and 10Y). The main reason for that is that we think market’s confidence on the Fed’s 4 or plus hikes will slow down in the coming months on the back of lower-than expected fundamental, depriving the yield curve from steepening too much.

Chart: Gold prices vs. US 5Y TIPS (inv.) (Source: Reuters Eikon) 

WeeklyGold.PNG

 

Weekly Chart: TOPIX vs. USDJPY

As we always like to look at the Japanese Yen charts (USDJPY, AUDJPY, MXNJPY) as a sort of alternative barometer of investors sentiment and overall financial conditions, we chose an interesting chart this week that shows a scatter plot of the Japanese equity market (TOPIX) with USDJPY. The two assets have shown a significant relationship over the years, especially since Abe took office in Q4 2012 and the BoJ introduced QQME (i.e. extremely accommodative monetary policy) on April 3rd 2013. Investor Kyle Bass was one of the first to introduce the term Pavlovian response to this ‘weaker yen, higher equities’ relationship in Japan, which brought a lot of ‘macro tourists’ instead of long-term investors.

However, we noticed that the relationship between the Yen and the TOPIX broke down in Q2 2017. While the Japanese equity market has continued to soar over the past few months, currently flirting with the 1,900 psychological level (its highest level since 1991), USDJPY has been less trendy and has been ranging between 107 and 114 (see divergence here). Hence, we decided to plot a scatter chart between the two assets using a weekly frequency since 2001.

As you can see, a strong Japanese Yen (i.e. USDJPY below 100) usually goes in pair with a weak equity market. For instance, we barely see the TOPIX index above 1,000 when the USDJPY trades below the psychological 100 level. However, as the exchange rate increases, we see more dispersion around the upward sloping linear trend; for a spot rate of 120, we had times when the TOPIX was trading at 800 and other times when it was trading at 1,800. We did a simple exercise and regress the exchange rate returns on the equity returns (both log terms) to see if we get some significant results, using the following equation:

USDJPY Analysis.PNG

As you can see, the coefficient Beta is economically and statistically significant at a 1-percent level. Using 16 years of data, we find that a 1-percent increase in USDJPY spot rate is associated with a 0.76% increase in the stock market.

We highlighted the point where we currently are in the chart (Today), which is a TOPIX at 1,889, its highest level in the sample, for a USDJPY spot rate of 112.80. We can notice that the point is located at an extreme level of dispersion, and the question we raised a few weeks ago was ‘Can the divergence between the equity index and the exchange rate continue for a while?’

We think that the stock market in Japan will struggle to reach new highs and generate some potential interesting returns in the months to come due to the poor performance of the banking system (strong weigh in the index) and the constant decrease in the effectiveness of the BoJ policy measures. We mentioned a month ago that the Japanese Yen was 26% ‘undervalued’ relative to its 23Y average value of 99.3 according to the Real Effective Exchange Rate (REER valuation) (see here), hence we find it difficult to imagine a super bear JPY / Bull TOPIX scenario. In addition, we also raised the fact that the current level of oil prices were going to deteriorate Japan Trade Balance in the future (see here), pushing back the current account in the negative territory and potentially impacting the stock market.

Chart: Scatter plot of TOPIX vs. USDJPY – weekly frequency (Source: Reuters Eikon) 

TOPIXvsUSDJPY.PNG

Weekly Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

Weekly Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Weekly Chart: US 2Y10Y yield curve vs. USDJPY

Among all the potential compatible candidates that show an interesting correlation vis-à-vis the USDJPY (i.e. 10-year US-Japan interest rate differential, Topix index …), I chose this week to overlay the currency pair with the US 2Y10Y yield curve. If we look at the past three years of data, we can notice an interesting development that has started since mid-April of this year. While the US yield curve and USDJY has shown strong co movement between January 2015 and April 2017, it has been a different story over the past 8 months.

In the US, the yield curve has constantly been falling and is currently trading at 51.5bps half the value where it was sitting in April 2017. On the other hand, the Japanese Yen has been oscillating within a 7-figure against the green back, between 107.50 and 114.50. What is interesting about this divergence is that it started more or less at the same time of the Topix vs. USDJPY divergence, with Japanese equities soaring from 1,500 to 1,800 and a Yen mean reverting around 111 against the USD ( see tweet Topix vs. USDJPY).

The question now is: How long can this divergence persist in the near to medium term? The current level of the US yield curve has raised the concern of many market participants as in theory it is viewed as a strong predictor of future recessions. Looking at economic and financial data, I don’t personally believe that we are very close to a potential recession in the US; in addition, the yield curve is still far from its extreme lows of -20bps and -95bps we saw in November 2006 and May 2000 (if we just look at the past 30 years of data). However, I think that we may see some US Dollar weakness against the Japanese Yen, on a back of slowly disappointing fundamentals (easing all the excitement on the expected Fed rate hikes) and geopolitical uncertainty. Moreover, the Japanese Yen is 26% ‘undervalued’ relative to its 23Y average of 99.3 according to the real effective exchange rate ( see JPY REER).

Chart: USDJPY (Candlesticks, rhs) vs. US 2Y10Y yield curve (Source: Bloomberg)

JPY US Curve