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

Ahead of the ECB and Fed meetings: watch the VIX

In this very quiet week, the SP500 is once again ‘playing’ with the 2,100 level and I strongly believe that it could be a perfect time to go short if you think about the upside / downside risk. There are many events coming up starting with the ECB meeting tomorrow and Non-Farm Payrolls on Friday. I guess we could see some volatility coming from these events which could impact equities and the FX market. As I wrote here, we saw that usually EURUSD tends to be positively correlated to sudden rise in volatility. Even though we expect the ECB to keep its rates steady (deposit at -0.4%, refi at 0% and marginal lending facility at 0.25%) with no increase in the current 80-billion-euro QE program, the market may react negatively during Draghi’s conference starting 1.30pm. Once again, the ECB could disappoint, leading to equities sell-off and some Euro appreciation. As you can see it in the chart below, EURUSD has entered in a bearish trend since May 3rd, decreasing by 5 figures until it hit its 200-SMA (yellow line) at 1.11. It has been trading within a 90-pip range over the past 3 days and I expect the currency pair to stay rangy today as well; however I would pay attention to the potential spike we can see tomorrow. The first strong resistance on the upside stands at 1.1250, a breakout could directly lead us towards the 1.1350 – 1.1400 range.

EURUSD

(Source: Bloomberg)

In addition, US non-farm payrolls could disappoint on Friday (Bloomberg survey at 160K) leading to another round of equity sell-off, sending the US 10-year yield back below 1.8% and pushing the Euro to higher levels. If we look back at the beginning-the-year sell-off in the chart below, the SP500 (candlesticks) fell by more than 200pts, the US 10-year (red line) crashed from 2.3% to 1.66% while the Euro (green line) surged by 7 figures to almost 1.14 against the greenback.

SPYields

(Source: Bloomberg)

Another reason to go short US equities at the moment could be a good strategy to hedge yourself against a volatility spike ahead of the FOMC meeting (June 14/15). If we look at the FedWatch Tool developed in the CME website, there is a 22.5% implied probability of a rate hike based on the CME 30-day Fed Funds futures prices.

FedWatch

(Source: CME Group)

However, the odds are higher based on the last few speeches delivered by US policymakers and of course a quiet market. In her 30-minute Q&A session with Greg Mankiw at Harvard on Friday, Fed Chairman Yellen said that the economy was continuing to improve and that a ‘rate hike in coming months may be appropriate’. In my opinion, I think a June move is appropriate, especially if equities still trade above 2,000 until that meeting. In addition, if we look at the Eurodollar futures market, time deposits denominated in US dollars and held at banks outside of the United States, the June contract trades 99.28 (i.e. the implied rates is at 72bps). Eurodollar contracts are useful to look at as well as they are more liquid than Fed Funds futures.

The only reason I see for no rate hike this meeting is if we see another sharp sell off within the next couple of weeks.

Gold: a response to more easing

Following my latest article on the Fed’s situation and a potential QE4 announcement next year if the situation deteriorates, I thought that a little article on gold could complete my overall view. As many other investors, I am trying to figure out where is the final bottom of the commodity. With all this currency debasement happening (and even more to come), I was wondering if agents will start to once again consider it as the ‘real money’ or – such as GS Jeffrey Currie calls it – the currency of the last resort.

The chart below shows the weekly prices of Gold since the late 90s; as you can see it, one ounce of Gold is now trading at 1,132 slightly above its 50% retracement (1,086.56) from a local low of 251.95 reached in August 1999 and a high of 1,921.17 reached in September 2011.

GOldhistory

(Source: Bloomberg) 

Even though many Gold experts are still bearish on the commodity forecasts with a first target at $1,050 per ounce, I am wondering if $1,100 is a good level to start buying as a long term investment. I understand that investors have considerably starting to lose interest as soon as they realized we were entering in a disinflationary-then-deflation area and that it was more interesting to be exposed to US bonds as real interest rates were increasing. As you know, Gold doesn’t distribute dividends or coupons (and also lacks the full faith and credit of most governments) and is only subject to capital appreciation. Hence, a good factor that can explain the majority of changes in gold prices over the past few years is indeed the changes in real rates.

However, if we considered the 2016 scenario of QE4 as a response to the EM meltdown, in addition to an all-in desperate Abe and Europe’s Great Depression, gold could potentially attract more and more buyers in this sophisticated period.

Quick review of Gold inventories figures

According to two main sources – Kitco and World Gold Council – there is 170,000 metric tons of ‘above-ground’ Gold (i.e. Gold that have been mined in all human history), which corresponds to approximately USD 6.8 trillion based on a spot value of 1,130 USD per troy ounce. If we look at the growth of the top central banks’ balance sheets over the past twenty years (see chart below), we can see than we have reached an historical high of more or less USD 16 trillion. Therefore, based on that information, we can easily do the math and conclude that the gold-to-monetary-base ratio stands now close to zero.

CBs

(Source: Bloomberg)

As you can notice on the chart above, we have now entered in a Central-Bank-money-printing area since the Great Financial Crisis and we are struggling to get out of it. As I described in my latest article, I believe that the Fed’s response to the EM crisis will be a QE4. Based on a statistical analysis, it is clear that this one will be less efficient that the previous ones; efficiency of QEs has a sort of logarithmic function until a point where there is no effect to the economy or even a negative effect to it. Therefore, new money into the system could trigger Gold prices to the upside as investors’ faith on central banks will be clearly reviewed on the downside.

Even though global annual gold mine production has risen to 3,000 tonnes in recent years (reported by the World Gold Council) compared to a 10-year production average of 2,700 tonnes, I don’t think it will add further pressure on the commodity price in the medium/long term. Especially now that we have reached a sort of unlimited-printing strategy. In addition, geopolitical pressures and macro conditions in some of the main producers (Australia, South Africa, Russia. see gold main producers in the map below) will slow and perhaps revert that trend in the coming quarters.

GoldProducers

(Source: World Gold Council)

To conclude, my view is that we could see a market’s response to gold as a sort of alternative currency to hold while we try to get out of this monetary debasement. The five-year chart clearly shows a negative trend, but I will try to add some gold in my portfolio at around 1,100 USD as a long term investment (and hedge).

GOldNow2

(Source: Bloomberg)

Pocketful of Miracles…

It is sure that things are not easy negotiating with its ‘partners’ as time goes on. As Latin poet Publilius Syrus once said ‘A small debt produces a debtor; a large one, an enemy’. I am now interested to see where the negotiations will go within the next few days.

First, let’s review quickly what is going on with Greek’s liabilities.

GreekDebt

(Source: Bloomberg)

The pie chart above shows us who ‘owns’ Greece’s public debt. According to the country’s Statistical Authority, Greece’s total public debt amounted €315.5bn  at the end of the third quarter of last year, which corresponds to roughly 180% as a share of the country’s GDP. As you can see it, the EFSF, the EZ temporary crisis-fighting fund, lent the country €141.8bn (which represents 45% of it) and the current weighted average maturity is 32.38 years with the last payment due in August 2053 according to the fund’s website. As you may have heard at the end of last year, the Board of Directors of the EFSF decided to grant Greece a two-month technical extension. The program will end on February 28th instead of December 31st last year. As a result, the remaining amount available (1.8bn Euros, which will raise the total amount to 143.6bn Euros) could still be disbursed to Greece (in need of assistance) until the end of this month.

Another major ‘creditor’ of Greek’s debt is the ECB, as a result of the Security Markets Programme (SMP), which currently owns about €27bn (i.e. represents 40% of the €67.5bn marketable debt outstanding). However, whereas EFSF loans where principal payments don’t start until 2023, Greek is set to pay 6.7bn Euros held to the ECB this summer (20 July: €3.5bn, 20 August: €3.2bn).

Eventually, the IMF is also an important creditor with 25 billion Euros according to the fund’s website, maturing currently. IMF loans in February and March are €3.5bn. As a reminder, the IMF’s policy is to never restructure its loan.

Therefore, if we add up the Greek Loan Facility (Bilateral Loans), the ECB holdings, the EFSF loans and the outstanding IMF credit, we get 246.7bn Euros, that is to say 78.2% of the total public debt. How convincing will the new Tsipras government be ‘against’ those figures?

It has been a rough start for Greece: the country’s news has been making the headlines since (and before) the election of the new government (January 25th). PM Tsipras has made it clear that Greek debt is unsustainable, condemning the country to a state of perpetual economic recession and deflation, and is trying to negotiate a write off with its debt creditors. In addition to that, he unveiled last Sunday plans to undo several austerity measures: gradually increasing the minimum wage, dropping the recent property tax and promised the retirement age wouldn’t be change (anymore).

However, this will be the tricky part of the deal – asking for a write off while easing austerity measures – as they don’t (or never) come together usually. Negotiate a debt write off, press for a relaxation of economic austerity, avoid a bank run, and on the top of that, maintain a political stability. It is interesting to see that investors are considering political risks once again after more than two years of main attention to the ECB and its programs and promises.

However, as many of you, I would agree that the market is underestimating the consequences of a Grexit clearly, not only the costs, but also contagion to other ‘weak’ peripheral economies (i.e. Portugal). What would happen to the Euro if the spread between peripheral and core yields (good sovereign risk indicator) starts to rise once again (like in early 2012)?

Quick view on EURUSD:

EURUSD broke its small resistance at 1.1350 yesterday after a quiet week, and seems on its way to retest the 1.1500 level. We saw earlier this morning that EZ grew by 0.3% in the last quarter of 2014, meaning that the 19-bloc economy grew by 0.9% during 2014, better than the 0.8% expected (see details in Appendix). However, Greek FinMin is making the headlines this morning: ‘Haircut preferable to loan extension’, which is obviously ‘capping the pair on the topside. A good entry level would be above 1.1460 (if it makes it up there), with a stop above for 1.1530 and a take profit at 1.1300. You can also play the bigger range, setting your stop above 1.1650 and take profit at 1.1200. However, I wouldn’t recommend to be too ‘greedy’ ahead of the Eurogroup meeting on Monday.

Otherwise, I stay strongly bearish on the Euro in the long term (vs. USD and GBP), as growth, monetary policy divergence, Grexit contagion, geopolitical tensions will clearly weigh on the single currency.

Appendix

EZGDP

(Source: EuroStat)