Monetary Policy Coordination: From Global Easing to Global ‘Tightening’

Abstract: An interesting series of central-bank announcements over the past semester confirmed my view of a global central banking monetary policy coordination. The first two major players that hinted in a speech that the central bank might slow down their asset purchases were the ECB and the BoJ; but more recently we heard hawkish comments coming from the BoC, RBA and even the BoE. In this article, I will first review the quantitative tightening (or the Fed balance sheet reduction program), followed by some comments on the current situation in the other major central banks combined with an FX analysis.

Link ==> US Dollar Analysis 2

Introducing the 3D challenge – Debt, Demographics and Disruption (with a US case study)

Abstract: As a response to the Financial Crisis of 2008, central banks have been running persistent loose monetary policies (NIRP and aggressive asset purchase programs) in order to generate some growth and inflation. Even though the measures chosen by policymakers mainly came from the burst in the housing market (US and Europe), developed economies have also been cornered with another long-term big issue: the 3D problem – Debt, Demographics and Disruption. Demographics reveal a dramatic aging of the developed world’s population (‘Baby Boom effect’), which has been playing a role in the desire of consumers to save more than actually spend. In addition, the long-term solvency of public and private plans has also been a growing concerns across the developed nations, adding pressure on current workers to increase their amount of savings based on a shift in expectations of higher taxes to sustain the secular change in demographics. The effect of an increase in savings have been one of the main factors of a decrease in inflation expectations across the world in addition to a sluggish growth, forcing policymakers to maintain a loose monetary policy, cutting rates to even negative territory and diversifying the asset purchase programs (corporate bonds, ETF and Real estate). The slowdown of inflation, and even deflation for some countries, is an issue for developed nations as it increases the country’s debt in real terms, putting the country under pressure and questioning its long run sustainability.

We then looked at the US economy for our case study on the 3D problem. Our analysis is composed of three sections: in the first one we quickly review US demographics challenge, then in the second section we present the US Federal and Household debt, and in the third part we introduce Disruption in different sectors of the US economy.

Link ==> 3D Problem

Retracing the US Dollar Q4 rise…

An important topic that has been making the headline over the past few weeks is the new surge of the US Dollar (vis-à-vis the major currencies) in the last quarter of 2016. Since its Obama Rise peak that occurred in mid-March 2015 (after a 25% appreciation), the US Dollar has been ranging against most of the major currencies (except the British pound due to political uncertainty and post-Brexit effect in June, and more recently the Mexican peso). The main reason for that long period of stagnation, in my opinion, was a shift in expectations of monetary policy in the US. After the Fed stepped out of the Bond Market (on October 28th 2014), market’s participants have been mainly focusing on the short-end of the curve, questioning themselves if the Fed was going to start a tightening monetary policy cycle. We saw a hike in December 2015 (25bps), which was immediately halted due to the market sell-off that followed afterwards (13% drawdown in US equities, 20% in Europe and Japan…). Therefore, the implied probability of a second hike in 2016 crashed, which was confirmed by the 7 FOMC meetings that followed (i.e. status quo).

Then, interest in the US Dollar started to emerge again in Q4 2016; the greenback experienced a 8%+ appreciation between October 1st and its December high of 13.65 (28th) according to the DXY index (Chart 1). There are a number of explanations to that recent surge: market was gradually pricing in a rate hike for the December meeting, political uncertainty rising in Europe or Infinite QE in Japan to protect the yield curve. All these stories make sense to explain the Dollar appreciation, therefore let’s retrace the important events that occurred in the last quarter of 2016.

Chart 1. US Dollar index in 2015-2016 (Source: Bloomberg)

usdollarhis

  1. Higher inflation and a positive post-Trump effect

First of all, the rebound in oil prices relieved pressure on energy-related companies [that have been falling one by one, applying to Chapter 11 bankruptcy] and had a positive effect on expected inflation. The price of a barrel has doubled since its February’s low of $26 and is currently trading slightly below $54 (Chart 2, red line) and obviously relieved US policymakers’ inflation anxiety. The 5Y5Y inflation swap forward (Chart 2, white line) stands now at 2.42%, higher than the 1.80% recorded last June. As a consequence, US long-term yields followed the move and the 10-year Treasury yield surged from a low of 1.36% reached in July last year to 2.44% today. With the unemployment rate below 5% and a Q3 GDP growth of 3.5% (annual QoQ), it seems inflation had been the main concern of the Fed’s officials in order to start tightening [again].

Therefore, on December 14th, US policymakers decide to raise the federal funds rate by 25bps to 0.5%-0.75% [and the discount rate from 1% to 1.25%], repeating a gradual policy path plan with three potential hikes in 2017. Even though it was considered to be the most ‘priced in’ hike of any Fed meeting ever, it pushed the implied rates to the upside with the current OIS (Chart 3, purple line) trading almost 1 percent above the OIS at the September meeting (Chart 3, red line). This change in implied rates was reflected in the Dollar appreciation.

Chart 2. US inflation overlaid with Oil Prices and US 10-year yield (Source: Bloomberg)

inflationus

Chart 3. Fed’s dot plot and implied rates (Source: Bloomberg)

FedPlot.JPG

I wasn’t very surprised when the Fed officials announced the rate hike, however I was wondering if we would have seen such optimism if equity markets ‘followed’ the global bond sell-off after the election (Trump effect). The positive US equity market reaction to Trump’s victory also comforted US policymakers for the December’s hike; I strongly believe that the decision would have been much harder if they had to deal with a sudden equity sell-off. Instead, the SP500 reached new record highs (2,277) last months.

One explanation of this development is based on investors’ expectation of an expansionary fiscal policy that will boost economic growth and inflation in the future, which are usually positive news for equities and negative news for bonds in theory (see Four Quadrants matrix – image 1).

Image 1. The ‘Four Quadrants’ framework (Source: Gavekal Research)

  Quandrant.png

   2. Political uncertainty rising in Europe, the rigger of many ‘forgotten’ problems

A popular trade that was running in the last quarter of 2016 was to be long the Italian-German 10-year spread ahead of the Italian referendum that occurred on December 4th. Market was pricing a potential rejection (55% chance), leading to an increase in political uncertainty in Europe, rising spreads between periphery and core and weakening the Euro.

If we look at Chart 4, we can see that the spike in the Italian 10-year yield (Chart 4, white line) could explain the Euro weakness (hence, USD strength). While the 10-year yield increased from 1.20% to 2.20% in two months (October and November), EURUSD (Chart 4, red line, inverted) went down 7 figures and reached a new low of 1.0350 post-referendum (59.1% of voters rejected the reform bill, which was followed immediately by PM Renzi’s resignation).

Even though yields have been decreasing over the past month (the 10-year now standing at 1.73%), political uncertainty could be the trigger of the two ‘delayed’  and ‘forgotten’ issues [or Black Swans] in Europe: the weak banking system and the Sovereign debt crisis. Not only Italy (in this case) cannot survive with higher yields (the country has 2.34 trillion EUR of outstanding debt – 132.6% of GDP – which needs to be rolled with low yields), but a sell-off in equities will increase the percentage of NPLs and potentially forced their banks to bail-in their depositors. The failure of Monte Paschi di Siena’s plan to raise 5-billion euros in capital from the market was ‘solved’ by a Nationalization (the bank’s third bailout). It was announced that the government will own at least 75% of the common equity after the bank is nationalized, a rescue that will cost the Italian government (i.e. taxpayers) about 6.6bn Euros according to the ECB (4.6bn Euros are needed to meet capital requirements and 2bn Euros to compensate the retail bondholders).

Therefore, I strongly believe that we will hear other similar stories in the year to come, as Italy is not the only country facing non-performing loans (NPLs) issues that affect the banking sector. Therefore, political uncertainty in Europe will weigh on the single currency and increase investors’ interest to the US Dollar.

Chart 4. Italian 10-year yield versus EURUSD (inv.) (Source: Bloomberg)

ItalyandEuro.JPG

   3. The weakness in the Japanese Yen

In Japan, the BoJ introduced the ‘Yield Control’ operation in order to stabilize the steepness of the JGB yield curve, offering to buy an unlimited amount of debt at fixed yields to prevent a significant surge in rates. This is kind of a puzzle, as Japan Officials cannot afford higher yields [as many indebted developed nations], however too-low yields impact revenues of the banking system and the pension / mutual funds.

I don’t think the particular surge in USDJPY was explained by this new ‘BoJ Operation’ and I prefer to say that the Yen depreciation was a result of a Risk-on effect post-US election result in addition to the recent spike in US yields. USDJPY (Chart 5, candlesticks) trades above 117 and equities (Chart 5, red line) are above the 19,000 level for the first time since September 2015; and you can see how the increase in US yields (Chart 5, blue line) is ‘responsible’ to the Yen weakness.

The question now is to know if the late Q4 Yen weakness will persist in early 2017, with USDJPY pair attracting more and more momentum investors looking to hit the 125 resistance. We know historically that the [positive] trend on the USDJPY can halt [and reverse] very quickly if investors are suddenly skeptical about the global macro situation (Fed delaying its 2017 hike path, China liquidity issues or rising yields in peripheral European countries). On the top of that, if market starts to price in inflation in 2017, will the BoJ be able to counter a JGB tantrum and keep the 10-year JGB yield at around 0%?

One important thing about this recent Yen weakness though is that it allows the Japanese government to buy time in order to implement new reforms and increase productivity. If you remember well, Abe stated in September 2015 his 20% increase in Japan GDP in the medium term (increase from 500tr to 600tr Yen in 5 years).

Chart 5. USDJPY, Nikkei 225 and US 10-year yield (Source: Bloomberg)

OverallJapan.JPG

   4. The Chinese Yuan devaluation

Another currency that has been making the headlines is the Chinese Yuan. Over the past year, the Chinese Yuan has shed roughly 7 percent of its value against the greenback (Chart 6, USDCNY in candlesticks). At the same FX reserves (Chart 6, blue line) have been shrinking; reserves plunged by $69.1bn to $3.05tr in November (most in 10 months), bringing the reduction in the stockpile to almost USD 1tr from a record $4 trillion reach in June 2014. As Horseman Capital noted in their article on China (Is China running out of money?), if FX reserves continue to plummet and the PBoC wants to maintain control of the exchange rate, Chinese officials will face some difficult choices. One option would be to raise interest rates (the benchmark one-year lending rate stands currently at 4.35%) in order to reduce outflows and attract interest in the Yuan (high interest rate differential vs. the other countries). This would have a negative effect on the country’s growth outlook, which is already concerning the developed economies due to the high levels of corporate debt and overheated property markets. Another option would be to reduce the holding of deposits by cutting the reserve requirement rate (RRR) which stands currently at 17%. We can see in Chart 7 that the Asset-Liabilities spread (represented by Foreign Currency Assets and Deposits from Other banks) has narrowed drastically over the past year, therefore cutting the reserve rates for banks could be a temporary solution for the PBoC. The problem of the second option is that it will continue to weaken the Chinese Yuan vis-à-vis the US Dollar, which could increase political tensions between US and China.

Interestingly, an asset that has [sort-of] tracked the USDCNY move this year is the Bitcoin (Chart 6, red line) , which raised from $400 in January last year to over $1,000 today. The cryptocurrency was described as the ‘good’ instrument to circumvent capital control in China in periods of large capital outflows like today. Like gold, Bitcoin is readily available in China and can be sold for foreign currencies without problems and therefore have attracted a lot of buyers over the past year.

Chart 6. USDCNY, Bitcoin and Chinese FX reserves (Source: Bloomberg)

ChinaOver.JPG

Chart 7. PBoC Balance Sheet (Source: Horseman Capital)

PBoCBaS.JPG

To conclude, there are several factors explaining the US Dollar strength in the last quarter of 2016, and it looks like the trend should continue in early 2017 (extreme monetary policy divergence to persist in 2017, black swan events coming from Europe, difficulties of Chinese officials to deal with the capital outflows…). However its trend cannot persist indefinitely as we know that it will eventually have negative effect on the US economy in the long term. For instance, we know that a strong dollar hurts US companies’ earnings, which is already a problem if we look at the 12-month forward earnings (Chart 8, green line). In addition, if long-term interest rates increase persistently in the future (breaking through the 3-percent level seen in the 2013 taper tantrum), the US could face a budget crisis: how is the government going to fund its budget deficit [which is expected to grow over USD 1 trillion again under Trump presidency] if China and other central banks are liquidating US Paper at record pace?

Chart 8. SP500 overlaid with 12-month forward earnings (Source: Bloomberg)

ForwardEarnings.JPG

FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore I think it is a good time to share my current FX positioning.

Fed’s meeting: hike or no-hike?

I think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

CME.png

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. I strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

ISM_US.JPG

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. I would stay short USDJPY as I don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

USDJPY.JPG

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). I don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore I don’t think we will see a lot of volatility in the coming days. I wouldn’t take an important position in the Euro, however I can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

eur

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. I would try to short some as I think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

I would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, my analysis stands close to the Yen’s one, and therefore I think the Swiss Franc strength could continue in the coming days. I like 0.96 as a first ‘shy’ target, and I would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Australia.png

(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). I don’t see any volatility rising in the next few weeks, therefore I wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, I think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

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.

Thoughts on Brexit and European Banks

Brexit and Cable 

I remember that two years ago, the same night of the kick-start of the World Cup in Brazil on June 12th 2014 (Brazil won 3-1 against Croatia), Mark Carney gave a speech at the Mansion House giving an update on the BoE’s monetary policy. At that time, he hinted that interest rates may rise sooner than had been expected; and the market was starting to price in a 25bps hike by the end of Q4 2014. Cable was trading at a (almost) 6-year high ($1.72) in a year when the British economy grew at its fastest pace for nine years at 2.8% (and the fastest-growing major economy in 2014 as you can see below).

UKgdp

(Source: Telegraph)

Two years later, the Official Bank rate is still at 0.5%, Cable is down 24% trading at around 1.33 after hitting a low of 1.2798 last week and the market has been positioned for a rate cut since Brexit in order to re-establish confidence in the UK market. While the BoE disappointed today by keeping the benchmark rate steady at 0.5% (only Gertjan Vlieghe voted for a 25bps cut) and no further easing, markets are pricing in a 80%+ chance of a rate-cut later this year with the September and December Short Sterling futures contract trading at 99.63 and 99.67 respectively (meaning that the implied rates are 37bps and 33bps).

Economists have slashed UK outlook and market participants are now expecting the UK economy to enter into a recession by the end of the year, mainly coming from a contraction in business investment and a sharp decrease in property prices. Major UK property funds (Aviva, M&G, Starndard Life, Aberdeen…) have suspended redemptions blaming uncertainty in the property market following Brexit. Therefore, a Summer Stimulus coming from the BoE could partially solve the UK current problematic situation.

The combination of an expected loose monetary policy in addition to poor fundamentals will continue to add pressure on the British pound in the coming months, and Cable could retest new lows toward 1.25.

A contagion in the European Banking system

I mentioned several times that a European Banking Crisis was one of the major Black Swans that could shake the market for a long period of time mainly due to a rise in the Non-Performing Loans (NPLs). For instance, in Italy, it was reported that 17% of banks’ loans are sour, a total of 360bn Euros of NPLs. To give you an idea, it was ‘only’ 5% in the US during 2008-2009. In consequence, Italian banks have been under attack (once again) with Monte Paschi now trading at 34 cents a share; the oldest surviving bank in the world (and Italian third largest lender) once traded at 93 Euros in May 2007, meaning that its market capitalization plummeted 99.6% in less than a decade. The five-year subordinated CDS is now trading at 1,506bps and the September 2020 subordinated bonds are now trading at 75 cents on the dollar. In response, the European Commission authorized Italy to use 150bn Euros of government guarantees to prevent a potential bank ‘run’ on deposits.

Even though the market has become less sensitive to ‘bad’ news coming from either Greece or Portugal, I strongly believe that Italy (or Spain) is one of the ‘scary’ countries to watch. If NPLs continue to rise in those countries, it will push Europe into a great depression and the write downs are going to be painful for all the stakeholders (equity holders, bond holders and depositors).

Another bank that investors have been following for a while now is Deutsche Bank. There is a funny chart (see below) that has been making the headlines which shows the bank’s share price over the past 18 months overlaid with Lehman’s share price before the collapse. The share hit an all-time low at 11.20 last week and lost 90% of its market cap since June 2007 high. Another scary figure is DB’s derivatives exposure of more than 70 trillion dollars, roughly equivalent to the world’s GDP.

DBandLehman

(Source: ZeroHedge)

 I think that European Banking Crisis is a topic that will stay on the table over the next few months, increasing the volatility in global equities and decreasing the effectiveness of the loose monetary policy run by the major central banks (i.e. ECB or BoJ). The Yen tends to appreciate in periods of massive sell off, hurting the main BoJ’s target (cheaper Yen for higher equities).

There are a lot of interesting topics to be discussed at the moment, and my next article will focus on Japan and the introduction of the Helicopter money.