Since 2008 the
single-minded focus of central banks has been the repair of the balance
sheets of the major international banks and sustaining the debt addicted
funding for sovereigns consuming more than they produce, reeling from slow
growth and chronic unemployment and incapable of fashioning Fiscal, Public &
Economic Policy solutions. In the world of the blind, one eyed Monetary
Policy has become King!
The urgently growing
problem now is a crisis in the global pension industry. The Macro Prudential
strategy of Financial Repression (negative real rates, penalized
savings, regulatory arbitrage and currency debasement) has worked effectively
for the banks and sovereign governments but has left those industries
requiring 'yield' in dire straits. It cannot be stressed enough how important
pension and insurance investments are to the life blood of the global
economy. Banks may get the press but those less understood, toiling in the
shadows, keep massive economic segments such as commercial real estate
(temporarily) afloat.
The solution has been for
these financial intermediaries to change regulatory and fiduciary risk
restrictions and increase riskier equity asset allocations. The magnitude of
underfunded pensions, the growing disconnect of the "8%" rule and
the tsunami of retirees now beginning to make claims, is forcing the
liquidity pumps to be sped up - not "tapered'. A 'Madoff Moment' is near
without continuing and uninterrupted flows (see: "FLOWS: Liquidity, Credit &
Debt" for
detail).
Euro Pressure Needs Relief
The equity markets in
Europe and the US have been on a tear as the new world of ABE-nomics reignited the dormant Japanese Carry trade and helped
the pension industry in a stealth fashion.
The correlations are
indisputable. Even Goldman Sachs recently outlined it couldn't explain a 22%
differential between what its combined Macro, Valuation and Risk models
suggested the S&P 500 should be trading at.
The new problem is the
strength of the Euro.
The Euro is seen to now
be stalling the EU recovery and potentially triggering another EU banking
crisis as CEE (Central and Eastern European) loans (denominated in Euros),
are rapidly becoming non-performing. (See: "Euro Pressure Going Critical")
Nowhere To Hide - Nowhere To Run
The "Carry"
trade has been in full force since the 2000 technology bubble burst. For 80
months a 41.6% devaluation in the US dollar powered a US$ Carry Trade with
low interest rates. With the financial crisis the Carry Trade shifted and the
Euro Carry emerged with 24.0% currency devaluation over a 51 month period.
Since October 2011 the Yen has resurfaced as the excepted Carry Trade. It
needs to be appreciated that this is a planned rotation by the currency
cartel, which controls 90% of the globe's currency trade.
As long as the Cartel all
debase together, in a coordinated 'rotating' fashion, there is seen to be
nowhere to hide!
Everyone is presently
focused on the central bank balance sheet growth. We did earlier as we
identified very coordinated patterns during 2010 and 2011.
Race To Debase
We additionally saw the
Cartel's debasement strategy unfold and tracked its coordinated responses.
The 'Original Sin'
What we are now watching
however, as part of our FLOWS work, is the shifting mechanics of the Carry
Trade. The "Original Sin" of International finance is to always
borrow in a currency that is devaluing and trending lower. Additionally, and
less appreciated is to flow investments through the currency cross that gives
the best differential change against the carry currency.
First, let's talk about
the sustainability of the current "Carry" in the Yen and then
recent developments in what may be emerging as the new currency cross of
choice. The current equity market melt-up is dependent on this for its
sustainability in the near to intermediate term.
YEN CARRY IN PLACE FOR
INTERMEDIATE TERM
The "Three
Arrows" of ABE-nomics are not working and we
can expect sustained and likely increased levels of BOJ Balance Sheet
expansion.
Hugh Hendry made
headlines when he recently became a 'tactical' market bull. An excerpt from his report is quite telling:
Consider the US
Treasury Inflation Protected Securities (TIPS) market. As you know, we allocate a lot
of time and risk capital to equities. Their malleability allied with low
transaction costs and liquidity makes them an excellent way for us to invest
in our macro narratives. But we find it hard to buy and sell equities based
on valuations. Doing it like this is just too imprecise. So we prefer the
certainty of inflation expectations: you should be long equities if
inflation expectations are trending higher -- or more specifically for us
when the 10-year inflation expectation, derived from the TIPS market, is
greater than its 200 day moving average.
Over the last decade you
could have done this and nothing else and escaped most criticism. A simple
trading rule where one is long S&P futures when the condition is met, and
flat otherwise, has produced a return of 75% since the 1st of January 2003
(around the bottom of the TMT crash). A long-only strategy has produced
better gains - almost 95% - but using the rule would have lowered your maximum
drawdown from 56% to just 20%. So once you adjust for volatility you can say
that you would have done better investing guided by trend inflation
expectations than not. The 10-year expectation moved below its 200 day
moving average in April this year. And yet we have taken a resolutely
contrarian message from this signal. Don't sell equities. China's pledge
to maintain high GDP growth rates by ploughing on with capacity enhancing
supply additions to its fixed capital formation, even at a time when the still
risk averse banking system in Europe and America is failing to produce a
consumer boom in the West, is fast building global deflationary pressure.
That's the resounding message from the TIPS market. And in a world of two way
causality, that could continue to prove immensely bullish. Why? Because
the Fed uses this criteria as its principal benchmark for determining whether
to taper or not.
.....
The most senior policy
makers at the Bank of Japan were unceremoniously removed from office and
monetary policy was set, instead, very loosely, propelling yen asset prices
higher. The stock market leapt by 60% on the news and the currency weakened
by 20%. And, as the chart above of the Japanese five-year break-even
inflation expectation reveals, one should be long their stock market. We
still value the one-touch at our purchase price today, and with the market
approaching 16k and trending higher, who is to say where it will trade in
April 2018?
Currency Cross - Short Term Shift
We showed above the tight
correlation between the EURJPY and the S&P 500. What is now
becoming more correlated is the GBPJPY!
Markets react to data.
The U.K. is a small open economy. It has thrown the kitchen sink at growth
and it may finally be beginning to be show some
results. Remember when Carney took the helm of the BOE people were quite
pessimistic, worried and then from there on things started to turn. So there
was already a backlog obviously. Then the confidence boost given the forward
guidance and the change of strategy helped.
What were the drivers
behind that growth? The main ingredients for the growth that we're seeing are
the funding for lending that has really spurred the credit creation more than
it has on the continent. The stabilization of the euro area as a whole has
helped confidence. People don't ask a lot about what's happening there, which
is a change. They ask more about Scotland than about the euro zone. It's
telling. Then the third thing, which is more structural, the U.K. labor
market has operated in a strange way relative to previous cycles, a more
continental way. So there's been less firing given economic circumstances,
which has meant that more people kept a job. Rates went down and that helped their disposable income stay stable or actually grow.
That has helped consumption and get the economy
going again. So there's a combination of forces and the market has reacted to
that. The market is likely not excessive. It's taking the view that the BOE
may be the first to hike in the cycle in late 2015 ahead of the Fed.
S&P500 Correlation
Bloomberg recently laid
out the case that the British Pound may be set for gains versus Japanese Yen:
The pound may continue to
climb versus the yen as risk appetite remains buoyant and the currency cross
breaks above key resistance.
The technical outlook may
attract investors to the options market. GBP/JPY has been most highly
correlated with the S&P 500, a proxy of global risk appetite, among the
variables of the cross-asset correlation matrices of the Bloomberg Currency
Chart book.
The daily
correlation in the last month between the percentage change of the exchange
rate and that of the S&P 500 stands at 0.61.
The figure for the last
three months is 0.44. The equity index hit a new record high last week. Loose
monetary policy around the world may continue to boost stocks.
In addition, the
moving-average cross-over technical overlay rule of the carry-trade tracker
signals JPY funded carry trades versus a basket of the currencies of
commodity-producing and emerging- market countries (AUD, BRL , MXN, NZD, TRY
and ZAR) should be opened.
It also indicates CHF
and USD funded carry trades should be closed.
The long/flat signal is
provided by a moving-average crossover technical overlay rule. The investor
goes long the carry-trade basket when the five-day moving average of the
cumulative returns is above the 30-day moving average and then closes that
position and goes flat when the five-day moving average falls below the
30-day moving average. (See: Rosenberg,
Michael R., Bloomberg FX Market Insights, July 8,
2009.)
GBP/JPY appears only
somewhat overvalued. It is about 19.3 percent above a Bloomberg Brief
calculation of its purchasing-power-parity equilibrium level and 2.7 percent
below its 10-year moving average. The average of those two numbers is 8.3
percent.
The technical outlook for
GBP/JPY also appears positive. The currency cross is pushing through
resistance created by the 38.2 percent retracement line of the decline from
the 2007 high to the 2011 low at 168.13. The next major resistance level is
created by the 50 percent retracement level of the same sell-off at 183.97.
The recent rally has left
the pair well above support created by the 55-day moving average, currently
at 159.31. That may attract investors to the options market. For example,
additional gains could be captured with an at- the-money three-month GBP
call/JPY put. It would cost 1.97 percent of the notional value of the trade,
according to the Bloomberg Professional Service.
The rally of the pound
versus the yen may be greater than that of the U.S. dollar versus the
Japanese currency as a result of seasonal patterns. The U.S. dollar has
weakened over the last 13 years during the month of December, especially
versus the euro, the Hungarian forint, the New Zealand dollar, the Polish
zloty, the Swedish Krona and the Swiss franc.
The depreciation has
averaged 2 percent versus the euro, 1.7 percent versus the Hungarian forint,
2.2 percent versus the New Zealand dollar, 2 percent versus the Polish zloty,
1.8 percent versus the Swedish Krona and 2.2 percent versus the Swiss franc.
Conclusions
We expect increasing
levels of BOJ Balance Sheet Expansion, a strengthening UK Sterling and a
shift in the Carry Trade dynamics. This may be unsettling to the equity
markets in the short term as the shift takes place but is likely to result in
a continued melt-up of the markets in the Intermediate term.
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