Global Macro: trade on China’s weak signs and Draghi’s Will to Power

This article deals with a few current hot topics:

  • The main one gives an update on weakening signs of giant China
  • The second one reviews the ECB Thursday’s meeting, presented with a couple of FX positioning
  • The last one is on the debt ceiling debate and risk-off sentiment

China desperately flowing…

As I am looking at the current news in the market, there has been a lot of interesting topics to study over the past couple of months. I will first start this article with an update on China and its weakening economy. Since the Chinese ‘devaluation’ on August 11th, I have been focusing much more in the EM and Asian Market as I strongly believe that the developed world is not yet ready for a China & Co. slowdown. I heard an interesting analysis lately, which was sort of describing the assets that had performed since the PBoC action more than two months ago. As you can see it on the chart below, Gold prices (XAU spot) accelerated from 1,100 to a high of 1,185 reached on October 14th, and Bitcoin recovered from its low of 200 reached in late August and now trades at $285 a piece.

ChinaandBitcoinGold

(Source: Bloomberg)

One additional explanation that I have for Gold is that I believe that the 1,100 level could be an interesting floor for long-term investors interested in the currency of the last resort. The weak macro, loose monetary policy, low interest rates and more and more currency crisis in EM countries will tend to bring back gravity in Gold, especially if prices become interesting (below $1,100 per ounce) for long-term buyers.

Looking at the CSI 300 Index, we still stand quite far from the [lower] historical high of 5,380 reached in the beginning of June last year. Since then, as a response, we had a Chinese devaluation, the PBoC cutting the minimum home down payment for buyers in cities last month (September 30th) from 30% to 25% due to weak property investment, and then a few days ago the PBoC cutting the Reserve Requirement Ratio (RRR) for all banks by 50bps to 17.50% and its benchmark lending rate by 25bps to 4.35%. Looking at all these actions concerns me on the health of the Chinese economy; it looks very artificial and speculative. In a late article, Steve Keen, a professor in economics explained that the Chinese private-debt-to-GDP ratio surged from 100% during the Great financial crisis to over 180% in the beginning of 2015, amassing the largest buildup of bad debt in history. Its addiction to over expand rapidly have left more than one in five homes vacant in China’s urban areas according to the Survey and Research for China Household Finance. Banks are well too exposed to equities and the housing market, and it looks that they have now started a similar decline as the US before 2008 and Japan before 1991. To give you an idea, the real estate was estimated to be at 6% of US GDP at the peak in 2005, whereas it represents roughly 20% of China’s GDP today.

ChinaPrivatedebt

(Source: Forbes article, Why China Had to Crash)

I wrote an article back last September where I mentioned that the Chinese economy will tend to slow down more quickly than analyst expect, therefore impacting the overall economy. We saw that GDP slide to 6.9% QoQ in the third quarter, its slowest pace since 2009 and quite far from the 7.5%-8% projection in the beginning of this year.

Draghi’s Will To Power

One fascinating event this week was the ECB meeting on Thursday. Despite a status quo on its interest rate policy, leaving deposit rate at -0.2% and the MRO at 5bps, a few words from the ECB president drove immediately the market’s attention. He said exactly that ‘The degree of monetary policy accommodation will need to be re-examined at our December policy meeting’, therefore implying that the current 1.1 trillion-euro program will be increased. As you can see it on the chart, EURUSD reacted quite sharply, declining from 1.1330 to a low of 1.0990 on Friday’s trading session, and sending equities – Euro Stoxx 50 Index – to a two-month high above 3,400. Italy 2-year yield was negative that day (hard to believe that it was trading above 7.5% in the end of November 2011).

ECBmeeting

(Source: Bloomberg)

 I am always curious and excited to see how a particular currency will fluctuate in this kind of important events (central banking meeting usually). One thing that I learned so far is to never be exposed against a central bank’s desire; you have two options, either stay out of it or be part of the trend.  I think EURUSD could continue to push to lower levels in the coming days, with the market slowly ‘swallowing’ Draghi’s comment. I think that the 1.0880 level as a first target is an interesting level with an entry level slightly below 1.1100 (stop above 1.1160).

USDJPY broke out of its two-month 119 – 121 in the middle of October down to almost 118, where it was considered as a buy-on-dip opportunity. It then levitated by 3 figures to 121.50 in the past couple of weeks spurred by a loose PBoC and ECB. The upside looks quite capped in the medium term if we don’t hear any news coming from the BoJ. The upside move on USDJPY looks almost over, 121.75 – 122 could be the key resistance level there.

USDJPYTrade

(Source: Bloomberg)

Potential volatility and risk-off sentiment coming from the debt ceiling debate

On overall, with US equities – SP500 index – quietly approaching its 2,100 key psychological resistance with a VIX slowly decreasing towards its 12.50 – 13 bargain level, I will keep an eye on the debt ceiling current debate in the US, which could trigger some risk-off sentiment in the next couple of weeks (i.e cap equities and USDJPY on the upside). Briefly, the Congress has to agree on raising the debt limit to a new high of 19.6tr USD proposed (from 18.1tr USD where it currently stands). The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing obligations, and the current debt ceiling proposal’s deadline is November 3rd. No agreement would mean that the US government could default on its debt obligations, which could potentially increase the volatility in the market.

The chart below shows the increase of the debt ceiling since the early 1970s, after the Nixon Shock announcement which led to the end of Bretton Woods and the exponential expansion of credit.

USceiling

(Source: The Burning Platform) 

Brazil, on the menu of the next FOMC meetings?

With the VIX index trading 10 points lower at 17.08 and a very rangy USDJPY (trading sideways at around 120), I believe there isn’t any new outstanding topic to talk about, therefore I decided that a little article on Brazil could do it ahead of this new week.

Brazil’s summary on a chart

I would like to start this review by first commenting the chart below, representing the key elements that I usually like to watch. As you can see, the SELIC (Blue/White line), Brazil’s central bank (CBB) target rate, stands now at a 9-year high of 14.25%. Since the end of 2012, CBB policymakers have started a tightening cycle and has been forced to maintain it especially over the past 12 months as the currency – Brazilian Real – is collapsing. The real (yellow line) has depreciated by 56% in one year and now trades at 3.76 against the greenback. Looking at the range over the past 9 years, it reached a low of 1.5360 in July 2011 and a high of 4.2480, which represents a 178% devaluation. This aggressive depreciation of the currency has led to inflationary pressures (CPI YoY – green line – printed at 9.5% in September) and the CDS spread 5 year rose from 126bps to 418bps (with a high of 545bps in the end of September).

BrazilSummaryC

(Source: Bloomberg)

Brazil’s dollar-denominated debt…

Clearly, the central bank has been constantly intervening in order to calm investors’ fear of a potential default. Based on a study from the Bank of International Settlement (Working Paper No 483), dollar borrowings in Brazil has reached more than 300 billion dollars (with giant Petrobras holding one third of the shares). Holding a dollar-denominated debt (Loans, debt securities or offshore issuance) means basically that you are short US Dollar. Therefore, if the Brazilian Real keeps depreciating against the US Dollar over the long-term, all these non-financial Brazilian companies will have difficulty in meeting their debt obligations. For instance, the chart below shows the consequence on a Brazilian Company – Petrobras – that holds almost USD100bn of US-denominated debt. Its 5-year CDS spread (White Line) more than doubled over the past 6 months from 390 to 830 bps (with a high of 1025bps in the end of September), the equity price (Yellow line) almost decreased by half of its value and the company’s perpetual 2115 bonds are now trading at 71 cents on the par.

PetrosSitC

(Source: Bloomberg)

Brazil’s fiscal situation

As we are looking at the country’s financial stability, let’s review how the government is handling its budget. Brazil has an on-balance-sheet debt-to-GDP ratio of roughly 65% (as of July 2015), which has been constantly rising over the past 5 years due to the end of the commodity super-cycle. Based on article from the The Economist, the country’s budget deficit was projected to grow to 9% of GDP in 2015, with interest payments reaching an outstanding 8% (as a share of GDP). Higher short term rates to protect the currency and higher long term rates as investors lose confidence on the country’s sustainability, this situation can only deteriorate in my opinion.

BrazilInterestPayment

(Source: The Economist)

Its projected 2.3% contraction for this year (Brazil has now printed two quarters of negative growth QoQ, -0.7% in Q1 and -1.9% in Q2) has ‘forced’ rating agencies to downgrade its credit rating to junk status (S&P reduced it to BB+ with negative outlook last September). As you understand, the country has now entered in the so-called ‘negative spiral’, which usually leads to a long recessionary period. Economist are already projecting a zero-growth for the year 2016, and this is assuming the country’s institutions respect their debt obligations.

Political instability: Congress and Rousseff divergence

On the top of the current catastrophic situation for this used-to-be prosperous EM country, Brazil faces a political turmoil. President Dilma Rousseff currently faces many enemies in Congress (i.e. Congress blocking budget proposals) which can only worsen the country’s financial stability . For instance, her plan to reinstate a tax on financial transactions last month (38bps levy, known as CPMF) which could have raised 70bn Reals a year in revenue was eventually withdrawn as Congress would never have approved it. We saw on Wednesday that Congress postponed for a fourth time voting on whether to overrule President Rousseff’s vetoes on extra spending. The bills she vetoed would increase public spending by over 100bn real over the next four years. The central bank recorded a primary fiscal result (government budget balance before interest payments of 0.75% of GDP in August, therefore cannot afford to spend more than.

To conclude, both the political and financial situations are to follow closely over the next few months and we will see if the Fed will look at Brazil as an additional threat for the EM crisis.

Japan update: Abenomics 2.0

As a sort of casual week end ‘routine’, I was watching the cross assets chart of the main economies that I usually follow. There are so many things that are happening at the moment, however a little update on Japan is always refreshing and useful.

The chart below shows the evolution of the equity market (Nikkei 225 index, Candles) overlaid with USDJPY (green line). As you can see, since Abe came into power in December 2012, there has been a sort of Pavlovian response to the massive monetary stimulus: currency depreciation has led to higher equities. However, the Nikkei 225 index closed at 17,725 on Friday and is down almost 15% from a high of 21,000 reached on August 11, whereas the currency has stabilized at around 120 and has been trading sideways over the past month with an 1-month ATM implied volatility down from 13.2 to 10.6% over the same period. If we look at the 20-day correlation (that I like to watch quite a bit) between the two asset classes, we are down from a high of 89% reached on August 24th to 38.1% in the last observation with an equity market being much more volatile.

EquityandYenC

(Source: Bloomberg)

In article I wrote back in September 2014 entitled The JPY and some overnight developments, I commented a bit on how Japanese Pension Funds (GPIF in my example) were decreasing their bonds allocation and switching to equities. And the questions I ask myself all the time is ‘Can the BoJ (and the other major CBs) lose against the equity market today?’ Indeed, the GPIF, which manages about $1.15 in assets, suffered a 9.4tr Yen loss between July and September according to Nomura Securities.

Abenomics 1.0 update…

We saw lately that Japan printed a negative GDP of 0.3% QoQ in the second quarter of 2015 and is potentially heading for a Quintuple-Dip recession in 7 years. In addition, the economy returned to deflation (for the first time since 2013) if we look at the CPI Nationwide Ex Fresh Food (-0.1% YoY in August, down from 3.4% in May 2014). We know that deflation and recession were both factors that Abe has been trying to fight and avoid, and the question is now ‘What is the next move?’

In a press conference on September 24th, PM Abe announced a sort-of new ‘arrow’ where the plan is to achieve a GDP target of 600 trillion Yen in the coming years (no specific time horizon mentioned as far as I know), which is 20% more from where the economy stands at the moment (JPY 500tr). In addition, he also target to increase the birth rate to 1.8 children per woman from the current low rate of 1.4 in order to make sure that the Japanese population don’t fall below 100 million in 50 years (from approximately 126 million today).

Clearly, this new announcement shows that the three-arrow plan has failed for the moment, and the BoJ only has been the major player in order to inflate prices over the past few years. I am wondering how this new plan is going to work in the middle of the recent EM economic turmoil. My view goes for additional stimulus, another 10 trillion Yen on the table which will bring the QQME program to a total of 90 trillion Yen. If you think about it, the BoJ is currently running a QE program almost as much as big as the Fed’s one in 2013 (85bn USD a month, 1 trillion USD per year) for an economy three times smaller than the US. Deceptions coming from Kuroda (i.e. no additional printing) could strengthen the Yen a little bit, but this will be seen as a new buying opportunities for traders or investors looking at the 135 medium-term retracement (against the US Dollar).

Here are a few figures and ratios to keep in my mind in the medium-term future…

Bank of Japan Total Assets

According to Bloomberg’s BJACTOTL Index, the BoJ’s balance sheet total assets increased by 210tr Yen since December 2012 and now stands at 368tr Yen. With an economy estimated at roughly 500tr Yen, the BoJ-total-assets-to-GDP ratio stands now at 73.6%.

JAPANassetC

(Source: Bloomberg)

Japan Banks total Assets

As of Q1 2015, the Japanese Banks reported a 1,818 trillion Yen exposure, which represents 363% as a share of the country’s GDP.

BanksJapanC

(Source: Bloomberg)

Based on the figures, you clearly understand that Japan’s government has been trying to push savers into stocks so Mrs Watanabe can take part of this artificial asset price inflation. However, a recent study from the Bank of Japan showed that Japanese households still had 52% of their assets in cash and bank deposits as of March 2015 (vs 13% for the American for instance).

The 15-percent recent drawdown in the equity market clearly shows sign of persistent ‘macro tourists’ investors, who are giving Abe and the BoJ board a hard time.

To conclude, the situation is still complicated in Japan, which is hard to believe based on the figures I just showed you. I strongly believe that Abe cannot fail in his plan, therefore if the new arrow needs more stimulus (which it does), we could see another 10 to 15 trillion on the table in the coming months. The medium term key level on USDJPY stands at 135, which brings us back to the high of March 2002.