Japan: Flirting with Helicopter Money

As I already mentioned in a few articles, the Yen strength over the past year was going to be a problem somehow for PM Abe and the BoJ. After reaching a high of 125.86 in the beginning of June last year, USDJPY has entered into a bearish trend since last summer [2015] with the Yen constantly appreciating on the back of disappointments coming from the BoJ (i.e. no more QE expansion). The pair reached a low of 99 post-Brexit, down by 21.3% from peak to trough, sending the equities down below 15,000 (a 30% drawdown from June high of 21,000). The plunge in the stock market was directly reflected in the performance of the Japanese pension and mutual funds; for instance, the USD 1.4 trillion GPIF lost more than USD 50bn for the 12 months through March 2016 (end of the fiscal year). The Fund, as the graph shows below (Source: GPIF) , has been selling its JGBs to the BoJ over the past few years due to Abenomics (the allocation declined from 67.4% in 2011 to 37.8% in 2015) and has mainly been increasing its allocation in domestic and international stocks. With more than USD 13 trillion of sovereign bonds trading at a negative yield – the Japan Yield Curve negative up to 15 years – you clearly understand why I am always saying that Abe and the BoJ cannot lose against the equity market.

GPIF

A the situation was getting even worse post-Brexit, with the Yen about to retest its key 100-level against the US Dollar, the Yen weakness halted suddenly on rumours of potential ‘Helicopter Money’ on the agenda.

It started when Reuters reported that former Fed chairman Bernanke was going to meet PM Abe and BoJ Kuroda in Tokyo to discuss Brexit and BoJ’s current negative interest rate policy. However, market participants started to price in a new move from the BoJ – i.e. Helicopter Money, a term coined by American economist Milton Friedman in 1969. In his paper ‘The Optimum Quantity of Money’, he wrote:

‘Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.’

In short, Helicopter Money is a way of stimulate the economy and generate some inflation by directly transferring money to the nation’s citizens. This money, as a contrary of refinancing operations or QE, will never be reimbursed.

Buy the rumors, sell the fact?

The effect on the currency was immediate, and USDJPY soared from 100 to [almost] 107 in the past 12 years, levitating equities as you can see it on the chart below (SP500 in yellow line overlaid with USDJPY candlesticks). It was confirmed that on the week ending July 15th, the Yen had his biggest drop in the 21st century. The SP500 index reached its all-time high of 2,175 today and in my opinion, the Yen weakness is the best explanation to equities testing new highs in the US.

SPandYen

(Source: Bloomberg)

Talking with Bernanke: Conversations and Rumors

As the meeting was held in private, we don’t have any detail on the conversation. On common sense, you would first think that the discussion would be on the potential BoJ retreat from the market as its figures are starting to be really concerning (35% of JGBs ownership, 55% of the country’s ETF, 85% total-assets-to-GDP ratio). It is clear that the BoJ cannot continue the 80-trillion-yen program forever, and from what we see in Japan [markets or fundamentals], the effectiveness of monetary policy is gone.

However, it looks to me that market participants are convinced that the BoJ will act further, which is to say adopt a new measure. This was clearly reflected in the currency move we saw, and they [better] come with something in the near future if Japan officials don’t want to see a Yen at 95 against the greenback. The next monetary policy meeting is on July 29th, an event to watch.

Introducing Helicopter Money

I run into a series of really nice and interesting articles over the past couple of weeks, and I will first start by introducing this chart from Jefferies that summarizes the different schemes of Helicopter Money very well.

chopper money schematic

I was only aware of the first scheme, where the central bank directly sends money to the households or directly underwrites JGBs. However, as Goldman noted, the second popular scheme would be to convert all the JGBs purchased by the BoJ on the secondary market into zero-coupon perpetual bonds. When you think that a quarter of Japan revenues from tax (and stamps) are used to service debt with the BoJ running out of inventories (i.e. JGBs) to buy, the second scheme makes a lot of sense in fact.

The other part that Goldman covered was on the legal and historical side. As the picture below (Source: Jefferies) shows you, Article 5 of Japan’s Public Finance Law ‘prohibits the BoJ from underwriting any public bonds’. However, under special circumstances, the BoJ may act so within limits approved by a Diet resolution. In other words, the BoJ can underwrite public bonds. The only problem is once Helicopter Money is adopted, it is difficult to stop it. Japan already ‘experienced helicopter money’ in the 1930s after it abandoned the gold standard on December 13th 1931. It first devalued the Yen by 40% in 1932 and 1933, and then engaged in large government deficit spending to stimulate its economy; it was called the Takahashi fiscal expansion (Japan FinMin, Takahashi Korekiyo, also referred as the Japanese ‘Keynes’). As Mark Metzler described in Lever of Empire: The International Gold Standard and the Crisis of Liberalism in Prewar Japan (2006), ‘increased government spending was funded by direct creation of money by the BoJ’.

helicopter primer 2

It was not until 1935 that inflation start rising, and the expansionary policies of Takahashi’s successor after the FinMin assassination in 1936 led the country to a balance of payments crisis and hyper-inflation.

‘Be careful what you wish for’.

In my opinion, as central banks shouldn’t be too focus on the currency, an interesting way of stimulating an economy would be by transferring money directly to citizens’ account. The BoJ could put a maturity date to the money they transfer (i.e. the citizen has one year maximum to spend the money he received), and ‘obliged’ their citizens to spend it on Japanese goods, therefore stimulating the internal demand and eventually leading to a positive feedback loop.

The announcement of additional measures from Japan in the near future should continue to weigh on the Yen, and USDJPY could easily re-reach 110 quite quickly if rumors become more and more real.

Japan: A Loss of faith in Abenomics

As I am currently writing an update on Japan current situation, with a brief introduction to helicopter money [a name that has been running around the street for the couple of weeks now], I would like to share the piece I wrote last month which will give you an overview of the country’s current situation.

Japan: A Loss of faith in Abenomics  (June 13th, 2016)

I. Quick Japanese recap story

A. Japan and the two lost decades

Since the private sector debt bubble burst in the early 1990s, Japan had been stuck in an ‘ugly deflationary deleveraging’ (also called the ‘Lost Two Decades’). For the past two decades, real growth has averaged 1.1% with a persistent deflation of -0.5%. This situation has led to an exponential expansion of the government debt which crossed the one quadrillion yen mark in August 2013 and a debt-to-GDP ratio of 230% (according to Bloomberg index GDDBJAPN Index), the highest in the developed world. To give you an idea, Japan’s debt is larger than the economies of Germany, UK and France combined.

Moreover, if you add in private and corporate debt, total Japanese debt stands at 500% as a share of GDP (vs. 350% in the US).

B. What is Abenomics?

With 10 different FinMin and 7 PrimeMin since 2006, the Japanese economy was desperately in need of a grand strategy. Therefore, the re-elected PM Shinzo Abe announced in December 2012 a suite of measures called Abenomics. His goal was to revive the Japanese economy with the so-called ‘three arrows’:

  1. Massive fiscal stimulus : the government announced in January 2013 that it will spend 10.3tr Yen in order to generate some growth, create about 600,000 jobs and increase the inflation rate.
  2. Quantitative easing : On April 4, the BoJ introduced its QQME ‘quantitative, qualitative monetary easing’ program in order to reach a 2-percent inflation, a program where the central bank will double the size of its monetary base from 138 to 270 trillion years over the next two fiscal years (fiscal year runs from April 1 to March 31 in Japan).
  3. Structural reforms : This is more a LT projects where PM Abe wants to increase Japan’s real economic growth rate to 3% by 2020 (compare to the 1%+ of the last two decades). The LDP party has several targets such as to foster trade, provide excellent education, raise women’s labour participation rate, improve infrastructure exports, reconstruct the Tohoku region. This arrow is more subjective and is not still understood by most of the people.

C. Consequences on the Japanese economy

Most of the effect of this massive stimulus program was reflected in the currency, with USDJPY soaring from the mid 70 range to 125.85 (Green line) in June last year, sending stock (Nikkei 225 – candlesticks) from 8,500 to 21,000, therefore raising hope of a Japanese recovery.

JapNikkei

(Source: Bloomberg)

The massive stimulus program generated some growth and inflation for the first year; as you can see it on the chart below, the inflation rate (Nationwide CPI YoY) hit a high of 3.7% in May 2014 and the economy grew by 1.4% in 2013.

JapanGDP

JapanInflation

(Source: Trading Economics)

However, this fairy-Abe story came to an end very quickly and was first reflected in the economy and the inflation, then in the Yen strength and equity since June last year. It is hard to believe that after all Abe/Kuroda efforts (i.e. expanding the BoJ balance sheet), we are now back in the same situation with an annual inflation rate at -0.3% and an economy close to entering into its fifth recession since the Great Financial Crisis.

II. What are the issues in Japan?

A. The vicious debt spiral

When it comes to Japan, the first thing to analyse is the country’s debt and fiscal situations. As we can see it on the chart below, Japan has constantly be running large amount of fiscal deficits (7-8% as a share of GDP) since GFC and obviously led to a ballooning debt-to-GDP ratio, which grew from 162% in 2007 to 230% in 2015. In their book This time is different, economists Carmen Reinhart and Kenneth Rogoff claimed that rising levels of government debt are associated with much weaker rates of economic growth, indeed negative ones. If debt reaches 90% of GDP or more, the risks of a large negative impact on long term growth become largely significant.

JapanDebt

JapanDe

(Source: Trading Economics)

The fact that Japan has never experienced market ‘attacks’ is because most of its debt (95%) is owned internally by major institutional investors (GPIF, Japan Post Bank and more recently the Bank of Japan). However, with now more than one quadrillion yen of public debt, Japan spends 17.6% of its tax and stamp revenues in interest payments (9.9tr Yen of the 57.6tr Yen revenues) as the ministry of finance reported it in their last highlights of the Budget for FY 2016 (see picture 1).

Studies (Moody’s) have shown that countries’ sustainability start to decline sharply if governments use more than 10% of their revenues from tax (and stamp) to cover the interest payments. In addition, the low-yield environment imposed by easy monetary policy run by the BoJ (negative interest rate and QQME purchases at a record high of 80tr Yen of Japanese Government Bonds) have allowed Japan to borrow at a negligible rate: the 5-year yield currently trades at -23bps, the 10-year at -11bps and the 30-year yield is at 33bps (June 1st 2016). In other words, it is free for the Japanese government to borrow in the market.

However, if yields start to rise in the future based on a lack of confidence from Japanese investors and institutions, and consequently Japan starts rolling their bonds with nominal rates of 2 or 3% on the 10Y / 30Y, the default rate will start to rise dramatically. In economics, this is known as the Keynesian debt-end point, when a country starts to spend a major cut of its revenues in debt interest payments.

Picture 1. Japan’s Expenditures and Revenues – FY 2016

JapanFiscal

(Source: FinMin)

Lower taxes, lower revenues: what is the model?

In order to restore a fiscal stability, the government decided to raise its VAT tax from 5%to 8% in April 2014 for the first time in years, with a plan to raise it again in October 2015 (ambitious plan). The result were catastrophic on the economy and Japan entered straight into a recession two quarters after the hike. As a result, officials decided to postpone the second raise (from 8 to 10%) to January 2017.

In recent news, PM Abe mentioned at the G-7 summit in Shima (i.e. hinted) that the second VAT rate hike was potentially going to postponed, perhaps as much as three years, in order to avoid another recession.

More importantly, Abe also pledged several times to follow through with a corporate-tax cut in order to ramp up domestic investment. The current tax rate stands at 32.11%, and the government plans to lower the effective tax rate below 30 percent ‘next year’ (precisely at 29.74%). This view will potentially ‘force’ the companies to use their cash piles for investment on plants and equipment.

It is true that the Japanese rate on corporations is one of the highest in the industrialized countries, however the question is: Can Japan afford to lower its corporate tax rate?  With PM Abe postponing the VAT rate hike as well, the consequence is that we could see higher debt interest payments as a share of revenues, rising the fear of a potentially technical default.

B. Demographics, the shrinking country…

In a recent study, the IMF showed that the population could drop below 100 million by 2048 from 127 million today, and as low as 61 million by 2085. As you can see it in the chart below, Japan population peaked at 128 million and is expected to shrink to 124 million by 2020.

JapanPop

(Source: IMF)

The country’s fertility rate declined from 4.0 post World War II to 1.38 today, below replacement level, making it difficult for the government to come up with primary surpluses in the next decade. The number of Japanese aged 65 or older has reached a new record of 26.7 percent (of the population); in addition, a third of the population is above 60. This situation has broad and severe implications as fewer workers and less labour will reduce the potential output of the country, making it difficult for Abe to reach a total 20% growth in the next five years. As a reminder, PM Abe announced in September 25th last year that his intention was to raise Japan’s GDP by 100tr Yen by 2021 (i.e. from 500tr to 600tr Yen).

The rising number of retirees will increase the government spending over the years, downgrading the sustainability of the country. Moreover, with less people entering the workforce than the ones leaving (see picture 2), and with the sovereign yield curve negative up to 15Y (i.e. killing pension funds and mutual funds revenues), pensions reforms will be implemented in the medium term, shrinking the consumption rate and therefore also impacting the country’s GDP. The $1.3-trillion GPIF fund (Government Pension Investment Fund), the world’s largest pension funds, saw a 6tr Yen ($54 bn) decline for the fiscal year ending in March, its biggest losses since the Great Financial crisis. Negative interest rate policy run by the BoJ in addition to the massive monetary stimulus program have pushed Japanese institutional investors to increase their exposure to equities. The problem as we saw is that these pension funds (such as the GPIF or Japan Post Bank) are now very sensitive to the recent moves we saw in equity. Since the Nikkei 225 index peaked in the end of June last year (20,952), the Japanese equities are now trading below 17,000, down 20% in almost a year. With these pension funds being very (or over) exposed to equities, it seems that Abe cannot lose his battle versus the Nikkei Index.

Picture 2. Japan demographics change (The Economist)

JapDemogr

C. Poor fundamentals (real wages conundrum, savings, manufacturing PMI)

  • Real wages conundrum: Despite a low unemployment rate at 3.2% (vs. 4.5% back in 2012), real wages (base wages adjusted from inflation) in Japan are sluggish and have been falling constantly since 2010 (see chart below), undermining the purchasing power of households. The optimistic plan to push companies to raise their wages has been constantly delayed or slowed down by the private sector, therefore making it difficult for the economy to sustain inflation, consumption and growth. Even though a lot of people see Japan as an exporter, the main contributor of the country’s GDP comes from consumption (60.7% as a share of GDP).

JapanRealW

  • Savings: After all these years of unlimited money printing (and negative interest rates), we now start to understand that the central bank’s goal is to force also individuals to put their savings into equities as holding cash in the bank doesn’t earn any interest. Despite Japanese banks not passing on the negative carry to their clients, we would have thought that the non-interest bearing account would drive savings down. However, Bank of America ML proved that NIRP policy doesn’t necessarily push savings rate down; with almost €2.6 trillion in negative-yielding debt in Europe, they discovered that savings were going up and not down. Economics studies have told us that negative rates should force people into higher yielding funds or vehicles (stocks for instance) with agents anticipating inflation in the near futures. In reality, BofA claim that ‘ultra-low rates may perversely be driving a greater propensity for consumers to save as retirement income becomes more uncertain’, therefore implying that in period of great uncertainty, nervous people don’t tend to spend but are more keen on saving.

BoARealWage

(Source: BoA)

Japan used to have one of the world’s highest savings rates, but it has constantly been falling from a high of 23.1% (of disposable income) in 1975 and has been oscillating around 0 percent since the turn of the century. However, most of this decline is due to the shrinking number of people in the workforce, however the new generation of workers (willing to take more risk) may be willing in building savings in case of a sluggish growth and the threat of a potential bond crisis.

  • Manufacturing sector is declining: we saw recently that the Nikkei Japan Manufacturing PMI plunged to a 40-month low in April at 47.7 (below its expansion level at 50), its weakest level since the start of Abenomics (See chart below). Economic weakness overseas (mainly coming from China’s slowdown) crashed exports and capital spending; in consequence, the end of the commodity super-cycle decreased demand for mining equipment. Moreover, according to Goldman Sachs research, companies in the western world have been using most of their earnings into dividends and stock buybacks instead of capital expenditure and research and development. Historically, it has been an important driver of long-term growth as capital investment make workers and companies more productive. Japanese companies today have the oldest equipment of the western economies due to the lost decades after the bubble burst in 1989.

ManufacturingJ

(Source: Japan FinMin)

D. International Trade are collapsing

We saw recently in a report from Bloomberg that global trade with Japan has been collapsing over the past three years. As you can see it on the chart below, exports are down 10.1% YoY and imports plummeted by 23.3% YoY (posting their 16th straight YoY drop). Therefore, the result is Japan have been showing trade surplus over the past couple of years (+7.5bn USD in April); looking at the trade balance ‘only’ isn’t enough to determine if the international trade activity is doing. We have the same situation that peripheral countries of the Euro Zone have experienced after the Great Financial Crisis, a recovering trade balance due to a collapse in imports.

In addition, with a Yen 14% stronger versus the US Dollar since June high, it is not going to help exports grow in the next few quarters, and may potentially increase the risk of another recession coming ahead.

ExportsJapan.png

(Source: Bloomberg)

III. Consequence of such measures

A. The BoJ’s hidden shadow

Based on the several issues we mentioned before, it is clear that Japan needed a weaker currency to reboost its economy after more than twenty years of sluggish growth and almost no inflation. Moreover, the fact that the country is located in an area where most of the countries have had an undervalued currency and cheap labour costs has had a major impact on Japanese international trade. However, the problem with running a sort of unlimited money printing strategy has a major dark side. Japan was the first developed economy to cut rates below 1% in January 1996 (chart below) and the first country to try QE in order to stimulate the economy and generate some growth and inflation. According to the BoJ, the total notes and coins in issue have reached 100 trillion Yen, with a 6tr Yen YoY increase in the last year. It is the highest rate in physical notes and coins since 2002, a year when fifty two banks went bankrupt in Japan.

QEJapan

(Source: Horseman Capital Management)

At the end of May 31 2016, the Bank of Japan’s balance sheet totalled 425.7 trillion Yen in assets (red line); government securities accounted for 370.5 trillion Yen. For an economy of roughly 500 trillion Yen, the central balance sheet total-asset-to-GDP ratio stands at 85%, an outstanding number compare to the major economies where the ratio stands between 20 and 30 percent.

In addition, by purchasing 80 trillion of JGBs every year, the BoJ is now the major holder the country’s government bonds with 35%. This ratio is expect to reach 50% by the end of 2017.

JapanOwnership JapanJGBs

(Source: Japan Macro Advisors)

The central bank is also purchasing 3.3tr Yen if ETFs and now owns 55% of the country’s ETF according to Bloomberg (see chart below). As the plan doesn’t seem big enough to stimulate Nikkei stocks, market participants speculate that the BoJ will eventually more than double the plan to 7 to 8 trillion Yen. As Bloomberg reported in April, the BoJ is now a ranked as a top 10 holder in more than 200 companies of the Nikkei 225. If the central bank increases its ETF purchases to 7 trillion Yen, Goldman Sachs reported that the BoJ could become the number 1 shareholders in 40 companies, and potentially the top owner in 90 companies with a 13-trillion program.

By purchasing and holding the Exchange-traded stock, the BoJ becomes the holder of the underlying stock; the central bank’s holdings amount to about 1.6% of the total capitalization of all the companies listed in Japan.

ETFJap

JapanHolders

(Source: Bloomberg)

This situation cannot last for too long, otherwise the companies’ valuation will start to be completely detached from the fundamentals. And what happens when the Bank of Japan starts exiting, will those valuations fall? It seems that in Japan, today, only BoJ matters…

B. Distorting the market

First of all, the consequence of running this long period of zero (now negative) interest rate policy in addition to all these QE rounds for the past 20 years have completely crashed the Japanese yield curve. Government bond yields are now negative up to 15Y, the 30Y yield trades at 31bps and the 6-month T-Bills reached a low of -0.31%. This low yield curve is destructive not only for pensions and mutual funds, but also for the bank earnings. It was reported by Moody’s that Japanese regional banks generated a mere 0.28% return on assets in FY2015. In their paper The influence of monetary policy on bank profitability, Borio & al. found that low interest rates and flat term structure tend to erode bank profitability.

MarketBonds

(Source: Bloomberg)

In addition, as the Bank of International Settlements noted, extreme monetary policy divergence between US and Japan rises the costs for Japanese financial institutions to get dollar loans. Historically, cross currency basis swap spreads has been zero but started to fluctuate since the global financial crisis. As you can see it on the chart below, the US dollar premium in FX swap markets widened substantially and reached a record of -120bps in early March. At the moment, it would cost 0.9% a year for a Japanese banks to hold a perfectly hedge (currency and duration risk) 5-year US Treasury Bond.

JapanBasis

(Source: Horseman Capital Management)

Fixed income investors are starting to front run Kuroda and are purchasing bonds not based on the creditworthiness of the companies but on pure speculation that the BoJ will purchase them. With investors today in desperate need for yields, inflows in the high-yield (i.e. risky) market has been rising over the past few years. The problem those high-yield companies could face in the next few years is if interest rates start to rise, a run on those yield funds could push a lot of companies into bankruptcies.

Moreover, bond market functionality has been deteriorating as many investors are kind of forced to look elsewhere for bonds that are easy to trade (it takes longer to make a given trade). This lack of liquidity creates these sudden risk in volatility as we saw in the beginning of this year. The JPX JGB VIX Index measures the implied volatility of the 10-year JGB futures contract. At the moment, the index trades at 2.2 pts, which means that the market’s estimation of the price fluctuation of 10-year JGB futures over the next 30 days is expected to be 2.2% per annum. In the chart below, we can see that the vol index surged to almost 6 pts in the beginning of the year as a post-reaction of the Negative interest rate policy announced by Kuroda on January 29th. The last time we saw such a move was in April 2013 after the QQME announcement.

ImpliedVol

(Source: Bloomberg)

IV. My view for the next five years

We strongly believe that the Japanese economy will continue to stagnate in the medium term, pushing or forcing Japanese policymakers to act even more. The nation citizens and the external investors will start to lose faith in Abenomics and therefore the macro tourists (investors that is looking at a short term opportunity) will withdraw their money from the equity market, potentially causing the Yen to appreciate in the beginning. However, in our view, Japan will face the so-called turning point between a currency devaluation and a currency crisis as the BoJ and the government will try all their best to protect the currency from appreciating.

Even though we think that we will sharp moves in the equity or bond markets, we are convinced that the best opportunity relies on the currency. If we look at the USDJPY chart below, despite a 36% depreciation that pushed the pair to 108 from the mid 70 levels, we stand far away from the 360 Yen per Dollar during the Bretton Woods area. We think that Japan needs another 50 to 100 percent currency depreciation to regain more competitiveness, which correspond to levels we saw back in the 1990s.

USDJPY

(Source: Bloomberg)

Since its return to the premiership in December 2012, Shinzo Abe has already become now Japan’s longest-serving prime ministers. However, his second term comes to an end in 2018 and the situation may start to deteriorate, gradually first then suddenly.

Consequently, sluggish growth in addition to a high debt burden and a shrinking population will not tend to push equities or real estate investments higher, raising the probability of a surge in non-performing loans. This is an episode that we already saw in the 90s after the bubble collapsed. We just think this time is different as the currency will not appreciate but depreciate.

Extreme monetary policy divergence to continue in the coming year…

We are conscious that the emergence of a potential crisis in the Japanese bond market will definitely shake the world’s economy as well. However, the depreciation will gradually be driven by an extreme monetary policy divergence coming in the next few quarters. The Federal Reserve chairman Janet Yellen expresses her views that the FOMC committee was ready to hike interest rates in the following months. A first hike was established in December last year after seven years of ZIRP policy run in the US as a response of the global financial crisis. Persistent QE in Japan (versus no money printing in the US since October 2014) in addition to short term interest rate differentials will constantly tend to push the currency USDJPY to higher levels.

In my opinion, there is no structural bids for the Yen anymore; each Yen appreciation that we experience since the announcement of QQME in April 2013 was a reaction to a sudden new risk emerging from the market followed by an investors’ response to ‘What is weak and what is cheap? The Yen’. To that extent, I strongly believe that each time there is an increase in the Yen’s value, it could be a good entry points for the new ones or a good to increase your long position on USDJPY, targeting 150 as a first level.

FX ‘picking’, who is the one to watch?

For the past couple of months, volatility has declined in all asset classes and traders (and algos) have switched to a range trading attitude. If we have a quick overview of the market, we can see that the S&P500 is still fighting against the 2,100 level, the VIX is gradually approaching its crucial 12 level, core bond yields are trading a bit higher (Bund is up 10bps, trading at 16bps) and EURUSD is trading in the middle of its 1.05 – 1.10 range.

However, in a more detailed analysis, we heard some noise lately that trigger a bit of movements in the FX market.

1. SNB talks, first round…

The first one was the CHF move. A few days ago, I posted on my twitter account a chart (see tweet @LFXYvan on April 19) that I thought could be problematic for the Swiss economy (i.e. SNB). At that time, EURCHF was gradually approaching the 1.0250 level, down from 1.08 a couple of months ago (5% appreciation).

Then, a couple of days later, SNB comments sent he Swissy tumbling, with EURCHF and USDCHF up 150 and 200 pips respectively. In its comments, the SNB announced that it reduced the group of sight deposit account holders (bank account through which transfers in the form of cashless payments and cash deposits and withdrawals can be effected) that are exempt from negatives rates, therefore transferring the ‘negative carry’ to its clients and in hope that Sight Deposits are reduced.

Looking at the charts, it seems that it wasn’t enough to force investors to run away from the Swiss Franc and I think we are on the path to retest new lows on EURCHF and USDCHF. With Swissy becoming once again the safe-haven asset since the end of the floor in mid-January, SNB Jordan will have to do more to prevent the exchange rate from appreciating ‘too much’.

2. Cable: will the ‘hawkish’ minutes floor the currency losses ahead of the UK general election?

Yesterday’s BoE minutes trigger a bit of appetite for the pound and sent Cable to a 1-month high of 1.5070. As you can see it on the chart below, the currency is now flirting with its 50-day moving average, an important resistance that could halt the pair’s late bullish trend.

GBP

(source: FXCM)

To be honest, I didn’t understand the sort of positive GBP reaction based on the central bank’s report. If we look at the big lines, the Committee voted unanimously to keep the Official Bank Rate steady at 0.5% (as expected), and in the 23rd section, it says that policymakers were expecting the 12-month CPI rate to fall into the negative territory at ‘some point in the coming months’. It sounds more neutral (if not so, slightly dovish) than hawkish to me.

With the (uncertain) general election coming ahead, I’d rather keep a short position on Cable, especially at current levels. Conservatives should keep a tight stop at 1.5160 for a first target at 1.4750, however I would widen the room there and suggest a stop at 1.5250 (RR of 1.3).

3. Follow the CAD move

Another mover was the CAD, alongside rising prices for oil, which surged by 6 figures to hit a three-month low of 1.2090 on Friday before coming back to 1.22 (against the greenback). With the Western Canadian Select June futures trading at a 11.50 spread against the WTI and higher than expected inflation rate (1.2% YoY in March vs. 1% consensus), the probability of another 25bp cut from the BoC in order to counter a lower growth economic forecast was revised (lower) by the market. It could potentially cap USDCAD on the upside, first resistance is seen at 1.2280, then the second stands at 1.2400. I would be comfortable with a little short position on USDCAD, targeting 1.2180 at first (stop above 1.2360).

CAD

(Source: FXCM)

4. Trade the Yen from a ‘Technicals’ perspective

I will finish this article with the Yen and Japan latest news. We saw earlier this week that Japan Trade Balance saw a tiny JPY3.3bn surplus (vs 409bn deficit expected) after 48 months of trade deficits. Even though it should be considered as good news (for a country which is expected to see a current account deficit for the first time in 34 years), the reason of that tiny surplus was driven by a collapse in imports, that plunged by 14.5% YoY (the most since November 2009). The Good news for Abe (and Kuroda) is that the stock market closed above the 20,000 level this week for the first time in 15 years, making a least one of the arrows – monetary stimulus – work.
As the Yen still remains one of my favorite currencies to watch on a daily basis, I had a lot of conversations with some friends of mine, and we (almost) all agree each time that the BoJ will lose completely control of its currency in the medium/long term. If you look at Japan core figures (debt-to-GDP ratio of 240% according to the IMF, a declining population with more than 25% Japanese aged 65 or over – out of 127ml, massive stimulus as a share of the country’s GDP…), the problem is easily spotted and the biggest ‘opportunity’ will be in the currency market in the medium term.

However, I am more skeptical (i.e. less comfortable) with the short-term trading. Now that the currency has passed its safe-haven status to the Swissy (see tweet @LFXYvan on March 24), I am usually looking for some buy-on-dips opportunities. Being short USDJPY sometimes scares me in the way that I don’t understand how the market interpret good news or bad news in Japan (therefore I always keep a tight stop for short positions).

One thing I am still comfortable in saying that, in an intra-day basis, USDJPY and the equity market (SP500) are still ‘breathing’ together, therefore one of them will ‘carry’ the other.

The wide range on the pair would be 115.50 – 122, but based on today’s volatility I am looking at the 118.30 – 120.80 window. Any breakout of the window could lead to another ‘readjustment’; something I am going to watch closely. If the currency keeps approaching the high of the range, it could be worth going short at 120.60 with a stop above 121.00 and a target at 119.50.

JPY

(Source: FXCM)

January 2015: A Rough Start

The past month has been quite eventful in the financial market and I am sure that some of the decisions (if not all) surprised many of us. After the SNB announce on January 15th, the ECB took over and unveiled a €60bn monthly QE (not open-ended) through September 2016; so 19 months at €60bn equals €1.14tr. The ECB, which has already been buying private assets such as covered bonds (a safe form of debt issued by banks) and ABS, will add an additional €50bn worth of public debt (bonds of national government and European institutions) to its current program starting in March this year. The purchases of these securities (in the secondary market) will be based on the Eurosystem NCB’s shares in the ECB’s capital.
In addition, President Draghi also added that the ECB will remove the 10bp spread on the TLTROs, and the interest rate applied will be equal to the rate on the Eurosystem’s MRO (5bp).

We saw on Friday that EZ preliminary inflation fell by 0.6% in January after a -0.2% print in December, the largest decline since July 2009 when prices also fell 0.6% following GFC.

The ECB decision(s) sent the Euro to newest lows last week, down to 1.1120 (11-year lows) against the greenback and below the 0.75 level (0.7440) against the pound. But more importantly, it sent a bigger amount of government debt in the negative territory (yields). According to JP Morgan, there is currently (approximately) €1.5tr of Euro area government bond with longer than 1-year maturity trading at negative yields over time, and a ‘mind-blowing’ €3.6tr of global government bond debt (nearly a fifth of the total) with negative yields as the chat below shows us. For instance, the entire 10-year Swiss curve is  now negative.

Global NIRP(Source: JPMorgan)

Another interesting topic is of course the 3 consecutive rate cuts (in 10 days) by the Danish Central Bank, that lowered it deposit rate to a record low of -0.5% to defend its peg and keep the Danish kroner (DKK) close to 7.46 per Euro (ERM II since 1999). EURDKK went down below 7.43; we will see this week how much policymakers spent in January in order to counter a DKK appreciation (some reports estimated that the central bank had to sell more than DKK 100bn). As a consequence (of the NIRP policy), a local bank – Nordea Kredit – is now offering a mortgage with a negative interest rate.
I believe the Danish krone is a currency to watch (in addition to the CHF) this month if the situation in Greece deteriorates.

A Weak Swiss Franc…
Since the SNB surprise, the Swiss has remained weak against the major currencies, with USDCHF up 7 figures  (trading currently at 0.93) and EURCHF up from parity to 1.0550. Analysts slashed their forecast for this year and are now predicting a recession (-0.5% according to the KOF Swiss Economic Institute). I like the chart below which shows the 12-month Probability of the top 10 countries to fall into recession in the coming months according to Bloomberg economist surveys.

Probarecession(Source: Bloomberg)

Japan and JPY still under threat over the long-run
In Japan, the 10-year JGB yield rose by 9bp in the last 10 days and is now trading at 29bps. USDJPY tumbled below 117 overnight on Grexit comments and Chinese manufacturing PMI contraction in January (49.8 vs. 50.2 expected), breaking its 117.25 support and extending its trading range to 116 – 118.75. ‘Buyers on dips’ reversed the trend and the pair is now trading at 117.60.
If we look at the long-run perspective in Japan, late macro indicators showed us that Abe’s government will have to do more. Real wages are still declining and fell the most in almost 5 years and the economy has now entered in a triple-dip recession (0.5% contraction QoQ in Q3). On the top of that, inflation has been weakening for the past 8 months as energy prices (mainly weak crude oil) weight on Japanese core inflation rate.
In addition, we saw that Japan plans a record budget deficit for next fiscal year (starting April 1st 2015) to support the economy. FinMin Taro Aso reported that government minister and the ruling coalition parties approved a 96.34tr Yen budget proposal for FY2015/2016. And I believe that we haven’t reached the peak yet, as Japan’s aging population (i.e. increasing social security spending) will ‘force’ the government to print larger and larger deficits. The IMF predicts that the country’s debt-to-GDP ratio will increase to 245% in 2015. It clearly shows that the USDJPY trend is not over yet, and there is further JPY weakness (and USD strength) to come.

On the other side of the Pacific Ocean, the US economy cooled in the fourth quarter. After the 5-percent Q3 print, GDP expanded at a 2.6% annual pace in the fourth quarter (first estimate). Net exports was the largest detractor from Q4 GDP (-1.02%) as imports grew faster than exports. King Dollar continues to benefit from the global weakness with the USD index trading slightly below 95. The equity market still handles the Fed’s withdrawal from the Bond Market with the S&P500 trading around 2,000 (looks like it is out of energy though), while US Treasury yields are compressing to new lows. The 10-year and the 30-year yields are trading at 1.67% and 2.25% respectively (which is quite concerning), and it seems the trend is not over yet. In regards to the inflation rate (that plummeted to 0.8% in December), the Fed delivered a hawkish statement last Wednesday (‘strong jobs gains’, ‘solid pace’ for economy), however dropping the entire ‘considerable time’ sentence and adding ‘inflation is anticipating to decline further in the near term’. The implied rate of the December 2015 Fed Funds futures contract is trading 30bps lower at 41 bps, while the December 2016 implied rate decreased by 60bps to 1.05bps in the past 6 weeks.

An important topic to follow this month will be developments in Greece which are moving very fast since the election on Sunday (January 25) and Syriza’s victory. ECB council Member Erkki Liikanen said over the week end that Greece needs to negotiate a deal before February 28th (when the Greek support program EFSF expires after the 2-month extension approved in December).

Japan and the Yen, where do we stand now?

On October 31st, Governor Kuroda announced that the BoJ will raise (by a 5-4 majority vote) its bond-buying program. We saw the reaction since then; USDJPY soared from 112+ then to 120 (with a high of 121.86 on December 7). Some analysts think that the move was/is exaggerated, but if you put the figures on table, it looks reasonable to me. By announcing that the Bank of Japan will buy between 8 and 12 trillion JPY of JGBs each month, it means that it will purchase the total 10tr Yen of new bonds issued by the Ministry of Finance; in other words, full monetization. As a reminder, the central bank is the largest single holder of JGBs (with 20%+ of the shares), and could end up owing half of the JP bond market within the next 3 to 4 years.

With the country now in a triple-dip recession (GDP contracted by 1.9% in the third quarter) and the inflation rate slowing down for the fourth consecutive month in November (core CPI, which excludes volatile fresh food but include oil products, rose 2.7% in November, down from 2.9% in September and 3% in October), I see just more ‘power’ coming from Japanese policymakers. Elected in December 2012 as Japan PM (the seventh one in the last decade), I am convinced that Abe (and Kuroda/Aso) cannot fail this time and will (and must) continue to go ‘all-in- on his plan. That will mean aggressive easing, therefore constant depreciation of the currency JPY in the MT/LT. Remember the graph I like to watch: Central Bank’s total assets as a percent of the country’s GDP (see article It is all about CBs).

In fact, as many analysts have stated, the hit from the sales tax increase back in April turned out to be bigger than expected. The second one, which was set for October 2015 and would have seen a 2-percent rise to 10 percent, has already been postponed for early 2017 according to Abe’s announcement last month. When will the country work on its budget balance? As a reminder, Japan has been showing a 8%+ budget deficit over the past six years, which rose the level of its debt to a ‘unsustainable’ 230% as a share of GDP.

Another major problem that the third-largest economy will have to deal with in the long term is its population. The chart below (Source: the Economist) shows the evolution of Japan’s population from 1950 to 2055 (forecast). It is aging, and that is terrible news for all the pension or mutual funds as many people from the Japanese workforce will switch from being net savers to net spenders.

20141213_gdc700(Source: the Economist)

With a population of 127 million in 2013, the number of people is expected to fall below 100 million by the middle of this century due to the low birth of rate (total fertility rate of 1.4 in 2013).

In my article last month on the Japanese Yen History, I added a quick ‘technical’ chart and stated that we may see some take profit a 120 and that the pair should stabilize at around that level based on the downtrend line. And each time I have some discussion about the Yen, I always say there are two ways to play it:
– either keep it short (against USD or GBP) for those who are looking for a medium or long term view;
– or buy the pair (USDJPY) on dips if you try to catch nice trends. Don’t try to short it, unless you are really confident and have been doing it for a while. All traders I know are looking for buying opportunities on the pair.

Speaking of that, it looks to me that the core portfolio I have been carrying over the past few months now – Short EUR (1/2) , JPY (1/2) vs. long USD (2/3) and GBP (1/3) – has been quite profitable, and I still believe there is more room. At least, it makes sense on the idea I had about ‘monetary policy divergence’, with the US and UK considering raising rates (no printing/QE) while EZ and Japan aggressively printing with NIRP/ZIRP monetary policies. I will try to write a piece shortly on the Euro while I am working on my 2015 outlook.

Risk-ON and US Dollar strength persist…

While tensions in Syria are still elevated with a second American ISIS fighter killed in a battle, Gazprom beginning accepting payment in Rubles and Chinese Yuan (via the ESPO – Eastern Siberia Pacific Ocean – pipeline), Ebola outbreak causing enormous damage to West African economies (economic growth expected to plunge by 4% in the region according to the African Development Bank), Argentina’s black market peso completely out of control tumbling to over 14 / USD (14.45 according to Argentine newspaper Ambito), French jobseekers surging to record high of 3.424 million (with PM Manuel Valls blaming the ECB to do more as QE was the solution to everything) and IMF head Christine Lagarde put under a formal probe for negligence in a corruption investigation… AUDJPY continues to climb and is now trading above the 97.00 level for the first time since June 2013 and the S&P500 closed above the 2,000 for the second time in history.

AUDJPY(1)

(Source: Reuters)

While European bourses have been also climbing during the same period with DAX and CAC40 both up approximately 6.5% for instance, yields on all German bonds out to 3 years are now negative (see current German yield curve in green) with the 10-year Bund 90.1bps and French 10-year OAT yield trading at all-time-low at 1.25%. The orange curve represents the German yield curve 1 month ago, and the histogram tells us the change over the past month).

image001(1)

(Source: Bloomberg)

Euro: the single currency still remains under pressure and is now trading below the 1.3200 level against the greenback, down 8 figures since May meeting (Draghi’s ‘ready to act next meeting’). It seems that the market is expecting more easing measures at the ECB meeting next week (September 4). As growth is weakening, the ECB will be much more intolerant of low inflation (flash August Inflation is expected to fall to 0.3% YoY from 0.4% the previous month) and high unemployment rate (currently stands at 11.5%). As a reminder, ECB staffs reduced its annual inflation forecasts in Q3 from 0.9% to 0.7% for the year 2014 and from 1.3% to 1.2% for 2015. With the 5Y5Y Euro inflation swap – ECB’s preferred measure of MT inflation – falling below the 2% level, investors are predicting another cut in the last quarter of this year therefore raising expectations of further measures from the ECB Governing Council. In addition, we saw this morning that loans to private sector fell by 1.6% in July (vs. -1.5% consensus) while M3 money supply grew by 1.8% from a revised 1.6% in June.

After Draghi delivered a dovish speech at the Jackson Hole central bankers’ meeting concerning the falling expectations of future EZ inflation, we heard yesterday that the ECB appointed money manager BlackRock to advise a program to buy ABS in order to revive the faltering Euro-area economy (announced at the June meeting). I would put public QE (sovereign bonds) option on aside for the moment, however I would opt for further updates concerning the ABS program and a potential rate cut. Otherwise, the next important date for the EZ will be on September 18, the first tranche of the so-called TLTROs.

The next support on EURUSD stands at 1.3150 (yesterday’s low), followed by 1.3100 (September 2013 low). Another interesting development to watch is EURCHF, which is now trading below the 1.2060 key support. The next support stands slightly above 1.2020 before the floor of 1.2000 (which remains our target in the coming weeks).

GBP: Sterling, the once used-to-be market’s darling, has fallen more than 6 figures since its mid-July high of 1.7191 and is now trading slightly below 1.6600. It broke its 200-day SMA on August 19 for the first time in more than a year, bringing in more participants in Cable’s bearish trend as the market likes trending market. If we have a look at the CFTC’s Commitments of Traders (see below), we can see that the net speculative positions fell from above 56K on July 1st to 13K+ reported on August 19th. I expect a pause at current levels in the coming days between 1.6550 and 1.6600.

COT-GBP(1)

(Source: OANDA)

UK strong GDP 2nd estimates (0.8% QoQ, 3.2% YoY) two weeks ago didn’t manage to bring investors’ interest on the British pound as annual inflation came in much cooler than expected in July at 1.6% YoY (vs. 1.8% eyed) shattering expectations of an early rate hike from the BoE. The implied rate of the Short-Sterling March 2015 futures contract is trading at 89bps, down from 1.15% in the beginning of July.

JPY: I will finish this article with a quick update on Japan and the Yen. Despite US yields running low, below the 2.40% level (trading at 2.33% at the moment), USDJPY broke its strong resistance at 103 to trade at 104.43 (Monday’s high) before edging back below the 104.00 level. We heard lately from Japanese Vice Economist Minister Nishimura that the Japanese economy may need more time than expected to swallow the sales tax hike (April 1st) and that the government may have to be more vigilant for the second planned one (October 2015). As a reminder, Japan GDP shrank by 6.8% (annual pace) in the second quarter and erased Q1 gains. The market is bearish on the JPY against most of the currencies and traders are quite confident that the government and especially the BoJ will do ‘whatever it takes’ to sustain Abe’s ambitious goal.

If we have a look at the recent figures, we saw that industrial production slid 3.4% MoM in June (biggest decline since the March 2011 disaster). JP trade balance deficit widened to 964bn Yen for July (vs expectations of a 702.50bn gap Yen) and the country reported a second current account deficit in June (399.1bn Yen) and the first January-June deficit in 29 years.

Important July figures to watch overnight: Core Nationwide CPI, expected to remain steady at 3.3%, Unemployment rate (also to remain steady at 3.7% according to consensus) and Preliminary Industrial Production (expected to tick up to 1.0% MoM after June’s decline).

Based on my last couple of discussions I had with some traders, it seems that the market is looking for buying opportunities on USDJPY. Pivot point is seen at 103.50/55, where there is talk of lots of buy orders.