A History of the British Pound

In today’s article, we will provide a recap of the history of the British Pound. According to the yearly BIS Foreign Exchange Turnover published in April 2016, the British pound is part of the G10 currencies and is the fourth most ‘traded’ currency with a daily average of 649 billion Dollars. Its percentage share of average daily turnover stands at 12.8%, and its two main ‘counterparties’ are the US Dollar ($470bn) and the Euro ($100bn).

Note that the exchange rate $/£ [or USD/GBP] is also called Cable, a term that derives from the advent of the telegraph in the mid-1800s. Transactions between the British pound and the US Dollar were executed via a Transatlantic Cable, and the first exchange rate was published in The Times on August 10th 1866.

This article will be split in two parts; the first one will [briefly] retrace the origin and the history of Sterling until the End of the Bretton Woods system in 1971, and the second part will explain the trends and reversals of Cable in addition to stating what I believe were the main drivers of the currency pair (from 1971 to today).

I. Origin and History of the Sterling pound between the mid-700s and the end of the Bretton Woods system (1971)

A. Quick history recap

Considered to be the oldest living currency in the world, the pound is 1,200 years old and was born in the latter half of the 8th Century, when silver pennies were the main currency in the Anglo-Saxon Kingdoms. The name [Sterling] pound (or Livre sterling in French) comes from the Latin word Libra Pondo, which means pound weight.

Back in the 8th century, 240 silver pennies represented one pound of weight and it was not until 1489 (under Henry VII) that appeared higher denominated coins with the first pound coin. Then, paper notes began to circulate after the establishment of the Bank of England in 1694, the world’s second oldest central bank (after the Sveriges Riksbank, the Swedish central bank). The Bank of England started as a ‘private company’ with the immediate purpose of raising funds for King William III’s war against France (issuing notes in return for deposits).

Even though there is an infinite amount of [inspiring] work on the Bank of England and the British currency, I am going to move directly to the 19th century when the British pound became the world’s reserve currency for a century after the Napoleon’s defeat at Waterloo in June 1815 (Foreign Exchange Reserves, Image 1). Great Britain arose as the leading exporter of manufactured goods and services and the largest importer of food and industrial raw materials. Between the mid-1800s and the outbreak of WWI in 1914, 60 percent of the global trade was invoices and settled in British pound (B. Eichengreen, 2005). London became the world’s financial capital in the late 19th century and the export of capital was a major based for the British economy until 1914. As foreign governments were seeking to borrow in sterling, British financial institutions established branches in the colonies and colonial banks opened offices in London. In 1913, Sterling’s share in the Official Foreign Exchange Assets stood at 48%, above Francs (31%) and Marks (15%) according to Lindert’s calculation (1969).

B. WWI outbreak and its consequence on the UK (and Sterling)

Although the US economy surpassed the British economy in size [in real terms] in 1872 (Gheary-Kamis, 1990), the important switch occurred in the early 1910s:

  • the US became an net creditor while the became a net debtor
  • and more importantly, the Federal Reserve was established in 1913 (December 23rd), with the enactment of the Federal Reserve Act

At the outbreak of WWI, the gold standard was suspended and restrictions were placed on the export of gold, which obviously had a negative impact on the British pound (vis-à-vis the US Dollar) as we can see it on Chart 2a. Prior to and during most of the 19th century, one pound was roughly worth 5 US Dollar (Chart 2b), with some ‘turbulence’ in 1860s due to the American Civil War.

Severe inflation (20%+), lack of demand, a high unemployment rate (above 10%) in addition to a 25-percent drop in economic output between 1918 and 1921 launched the Great Depression in United Kingdom at the end of WWI, which last for two decades. The pound first plummeted from $4.70 to $3.50 during that 3-year period before swinging back to its prewar levels (at $4.87).

C. ‘In between’ the Two Wars

The pound ‘rebound’ in the early 1920s (Chart 2a) could be explained by the political desire to maintain the value of Sterling at a ‘high’ rate (i.e. prewar levels) to give Britain an [economic] successful image to the rest of the World. In order achieve that, the UK had to run contractionary fiscal and monetary policy (Image 2a), which increased interest rate differentials (i.e. attracted savings in Britain) and pushed the UK inflation rate below the US one. As the US inflation rate was already very low at that time, the UK was experiencing deflation at that time (Image 2b).

Then, in 1925, Britain re-adopted a form of Gold Standard where the exchange rate was determined by the relative values of gold in the two countries, with a fixing at 4.86 US Dollar per unit of Pound. This Gold Standard ‘return’ was considered to be disastrous (Churchill’s biggest mistake as he was serving as the Chancellor of the Exchequer at that time), as it resulted in persistent deflation, high unemployment rate that led to the General Miners’ Strike of 1926. The UK was stuck in the debt vicious spiral; running a contractionary fiscal and monetary policy during a deflationary recession was increasing both the amount of UK debt in real terms and its burden (high interest rate increased the cost of borrowing). This led to a Balance of Payments issue, and led to a run on the pound. On the top of that, the Wall Street Crash and the beginning of the Great Depression put the British economy under intense pressure, which eventually came off the Gold Standard in September of 1931. In the year that followed, the British pound dropped to lower lows to around 3.25 against the US Dollar. However, as Barry Eichengreen noted in his paper Fetters of Gold and Paper, countries that came off the Gold Standard early (i.e. UK) did better [or less worse] than the countries that remained on it for longer (i.e. US). After a 3-year [1930-1932] pronounced deflationary period in the US (Image 3), rapidly rising prices in the summer of 1933 (after the US went eventually off the gold standard on June 5th 1933) eased the ‘strain’ on other countries and kicked off the dollar depreciation. The British pound rapidly recovered its losses and surged to a new high of $5 by 1934 (Chart 2a). The pound remained afloat and oscillated at around $5 until 1939 and the outbreak of WWII. This depreciation (which brought back the British pound to its low of 3.25 against the greenback) was mainly due to uncertainty around the outcome of the war, as fundamentals were expected to deteriorate very quickly (output collapse, a rise in inflation) indebting the British economy even more.

D. World War II and Bretton Woods period

In 1940, an agreement between the US and UK pegged the pound to the greenback at a rate of $4.03 per unit of pound. This exchange rate remained fixed during WWII and was maintained at the start of the Bretton Woods system (Chart 2a). British emerged from WWII with an unprecedented debt of nearly 250 percent as a share of GDP (most of it owned to the US) with ‘strong’ currency, a [much] less dominant market in terms of competitiveness and a degrading balance of payments (Hirsch, 1965). Despite the soft-loan agreement (a 3.75 billion-dollar loan to the UK by the US negotiated by JM Keynes at a low 2% interest rate with repayment over fifty years) to support British overseas expenditure post WWII, the British pound remained under intense pressure. Chancellor of the Exchequer Sir Stafford Cripps eventually announced a 30-percent pound devaluation from $4.03 to $2.80 in September 1949.

However, the devaluation was not enough as the following two decades were characterised by persistent balance of payment problems and led to the Sterling crisis of 1964-1967. The UK was forced to seek assistance from the Bank of International Settlement and the IMF more than once. Despite persistent current account deficits and a deteriorating balance of payments in 1964-1965 (Image 4), UK officials didn’t react (i.e. devalue) as they argued that devaluation would severely strain Britain’s relations with other countries when the main holders of sterling would begin to withdraw their balances from London and also threaten the international monetary system (Bordo & al., 2009). The pound weakness persisted in 1966 and 1967, covered by lines of credit received by other central banks (i.e. swaps with the NY Fed) and the IMF. But the government eventually ceded and PM Harold Wilson announced that the pound would be devalued from $2.80 to $2.40 on Saturday 18 November 1967. It then remained at that level until end of Bretton Woods.

II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971

Note that all the periods and important events are marked in Chart 1 (see end of article).

A. The Nixon 1971 Shock and Smithsonian Agreements (1971 – 1973)

In addition to signing the Smithsonian agreement at the December 1971 G10 meeting, where the US pledged to peg the dollar at $38 an ounce (instead of $35 during BW) with 2.25% trading bands (instead of 1 percent), the UK also agreed to appreciate their currency against the US Dollar. The pound was worth $2.65 by the end of the first quarter 1972.

B. 1973 – 1976: a rough start

However, it did not take too long for troubles to ‘come back’ in the UK and the pound experienced a series of speculative attacks in the mid-1970s. Cable hit a low of $1.5875 in the last quarter of 1976 and the UK had to call the IMF to counter persistent runs on Sterling. This loan was followed by a series of austerity measures, which helped reduce inflation and improve the economic activity, hence boosting the pound in the second half of the 1970s.

C. 1976 – 1980: US inflation and the Dollar depreciation

The positive UK-US carry trade due to low interest rate run by the Fed in the mid-1970s (as a response to the post first-oil shock recession) gave birth to a four-year shining period for Cable, which recovered by 54% to hit a high of $2.45 in the last quarter of 1980.

D. The V shape of the 1980s

I like to describe the 1980s as a V-shape curve for Cable as there were two major trends during that period. As a result of the second oil shock caused by the Shah revolution in Iran in 1979, oil prices doubled in the following year leading to a sharp increase in inflation in the US in 1979-1980 (peaked at 15% in the first quarter of 1980). In order to reign in the double-digit inflation, Fed chairman Volcker reacted immediately by orchestrating a series of interest rate hikes that levitated the Fed Funds target rate from 10% to nearly 20%. Even though the dramatic increase in interest rates caused a painful recession and a surge in unemployment rate (11%) in the US, it eventually led to international capital inflows as high [real] interest rates became attractive to foreign investment. What followed was a severe appreciation of the US dollar vis-à-vis the major currencies; Cable lost more than half of its value and hit a historical low of $1.0520 in the first quarter of 1985 (Chart 1). This Dollar Rise under the Reagan administration was a problem for the US economy as the current account fell into substantial and persistent deficit (Image 5a). In addition, the US was also running large budget deficit of 5%+ during the same period (Image 5b), which put the country in a twin deficits anomaly and caused considerable difficulties for the American industry (i.e. car producers, engineering and tech companies…).

Therefore, in order to re-boost the US economy, the Plaza Agreement was signed in New York on September 22nd 1985 and France, Japan, West Germany and the United Kingdom agreed to depreciate the US Dollar by intervening in the currency markets. This decision created a secular change in the financial market and immediately reversed the 5-year bull momentum on the US Dollar. The Pound reacted and appreciated roughly 80 percent in the following three years. I am not sure if the [financial] sentence ‘Don’t fight the central banks’ came from this decade, but I think it is a good example to show you how much effect a central bank cohort move can have on the market.

E. 1988 – 1992: the volatile period

We saw a consolidation between 1988 and 1989 to $1.51 after Margaret Thatcher’s Chancellor of the Exchequer Lord Lawson decided to unofficially peg the British pound to the German Mark (UK wasn’t in the Exchange Rate Mechanism yet (Image 8, green period). This caused inflation, a credit bubble and a property boom that eventually crashed in 1989-1990 followed by a recession.

Cable started to recover in the first quarter of 1990 as the interest rate differential increased preference for the British pound (Chart 3). In the middle of 1989, the Federal Reserve began to run a loose monetary policy in order to boost the US economy weakened by the Savings and Loan crisis of the 1980s and 1990s. Fed’s chair Alan Greenspan decreased the Fed Funds rate from 9.75% in March 1989 to 3% in September 1992 to boost productivity (Chart 3). Cable double topped at [perfect] resistance $2.00, a first time in Q1 1991 and a second time in Q3 1992.

It is also important to note that during that time, the Conservative government (Third Thatcher ministry) decided to join the Exchange Rate Mechanism on October 8th 1990 (Image 8, grey period), with the pound set at DM2.95.

16 September 1992: Black Wednesday and ERM exit (Source: Inside the House of Money)

Also called [another] Sterling crisis, the British government was forced to withdraw the Pound Sterling from the ERM on that day, sending the pound into a free fall. Cable tumbled by 30% from [Q3 92] peak to [Q1 93] trough. But what really happened then?

As we mentioned before, the UK tardily joined the ERM in 1990 at a central parity rate of DM2.95 and a trading range band of +/- 6 percent. The exchange rate was arguable judge too strong by many economists at that time, therefore the overvalued currency in addition to high interest rates and falling house prices led the country into a recession in 1991. It became difficult for UK officials to maintain the value of the Pound at around its target against the Deutsch Mark. Meanwhile, Germany was suffering inflationary effects from the 1989-1990 Unification, which led to high interest rates. Therefore, despite a recession, the UK was ‘forced’ to keep interest rates high (10% in September) to maintain the currency regime. Speculation began and global macro traders (i.e. Soros) increasingly sold pounds against the Deutsche Mark. To discourage speculation, UK Chancellor Lamont increased rates to 12% on September 16th with a promise to raise them again to 15%. However, traders continued to sell British pounds, as they knew that increasing rates to defend a currency during a recession is an unsustainable policy.

Eventually, on 16 September 1992, the UK government announced that it would no longer defend the trading band and withdrew the pound of the ERM system. The pound lost 15 percent of its value against the DM in the following weeks and traded as low as DM2.16 in 1995.

Even though we usually do our analysis of a specific currency vis-à-vis the US Dollar, I thought it was important to mention the presence of the Deutsch Mark as it explained Cable’s depreciation in 1992 and 1993.

F. 1993 – 1998: the Dull period with shy Sterling Gains

After the ERM exit, it was dull period for the USD/GBP, Cable oscillated around $1.60 with a shy little upward trend (i.e. shy GBP gains) helped by the small interest rate differentials and a series of trade balance surpluses. It looks like the $1.70 psychological resistance was hard to break between 1996 and 1998 and the Pound traded within a ‘tight’ 10-figure range during these years.

One important event during that period was that the Monetary Policy Committee was given operational responsibility for setting interest rates in 1997 with one [only] mandate: maintain a 2-percent inflation rate in the long run. Traditionally, the Treasury set interest rates.

G. 1999 – 2002: The Sterling Depreciation

 As we saw for the Euro (and the Yen at a lesser extent), the turn of the century was marked by a Dollar appreciation between 1999 and 2002. Cable lost a bit of steam during that period and spent a lot of time flirting with the $1.40 support in 2000 and 2001 (it even hit a low of $1.37 in Q2 2001). I have not found any supportive literature to explain this downward bias, but it is not absurd to assume that some of the dollar strength came from a surge in the equity market capitalization in the US – with the Tech Boom – and potentially a higher productivity than in the United Kingdom.

H. The 2002 – 2008 GBP appreciation (or US Dollar depreciation)

The US Dollar started to tumble in late 2001 / early 2002, which was the beginning of a 6-year bull period for Cable. The exchange rate went north 50% and reached a high of $2.11 in the last quarter of 2007 (with a small consolidation in 2005). The (inflation-adjusted) trade-weighted dollar exchange rate (i.e. see REER) steadily depreciated, falling by roughly 25 percent (Image 6). During that period, US was printing persistent twin deficits: Current Account deficits print a high of 6 percent in 2006 (Image 7a) while Budget deficits were ranging between 2 and 3.5 percent as a share of GDP (Image 7b). In addition, the Fed decreased interest rates to 1.75% after the 9/11 attacks and then to 1 percent in 2003, helping the government to roll its debt at lower costs and finance the Iraq War (total cost to the United States was at 3 trillion USD according to Stiglitz and Bilmes, 2010).

I. 2008: Financial Crisis and the Risk-Off aversion

The British pound saw a massive depreciation in 2008 due to the risk-off sentiment and the sudden demand for Dollars; Cable tumbled 36%+ from [Q4 2007] peak of $2.11 to [Q1 2009] trough of $1.35. In the early 21th century, Sterling had lost its reserve currency for a long time, so when asset prices took a massive hit in 2007-2008 the pound did too. The two currencies that acted as ‘strong’ safe-havens were the US Dollar and the Japanese Yen. This raised an interesting debate on whether countries should have huge amount of debt (denominated in their local currency) in order to have a currency that acts as a safe-haven in harsh period. When you think about it, the two safe-havens are the currencies of the two most indebted nations ($20tr for the US and $11tr for Japan, as of today).

The UK was sharply impacted by the crisis; to give you an idea, the pound’s [36-percent] fall vis-à-vis the US Dollar wasn’t even enough to make up for weakening foreign demand. It took the country’s economy 6 years to come back to its pre-crisis level (summer 2014, ONS), with a debt-to-GDP ratio that soared from 51% in 2008 to 89% in 2014.

Bank of England’s answer: Like many other central banks, the BoE slashed rates from 5 percent in the beginning of 2008 to 0.5% in Q1 2009 (the lowest since the BoE establishment in 1694). In addition, the Bank of England press the QE bottom like in the US and created £375bn of new money between 2009 and 2012.

The series of measures adopted by central bankers brought back interest in the Sterling pound, considered to be ‘cheap’ or undervalued relative to its peers. Cable regained 50% of its value in three quarters and hit a high of $1.71 during the third quarter of 2009; however, the recovery wasn’t very long as the Sovereign debt crisis emerged in Europe (at that time is was Greece) and impacted the British economy (and its currency) as well.

J. 2011 – summer 2013: the other dull period

Bizarrely, the British pound wasn’t affected too much during the [second] EZ sovereign debt crisis between Q3 2011 and mid-2012. For almost two-and-a-half years, Cable traded around $1.50-$1.60 with pressure on the downside in the beginning of 2013. The pressure came after it lost its top AAA credit rating for the first time since 1978 on expectations that growth would ‘remain sluggish over the next few years’. At that time, traders were starting to predict that Cable would retest its 1.40-1.4250 support range as the Pound was clearly not a hot currency in the beginning of 2013. In addition, investors were also starting to look at the Euro’s momentum after the buy-on-dips that followed Draghi’s ‘Whatever it takes’ in July 2012.

Despite the UK weakness, the British pound didn’t fall to further levels as it was ‘saved’ by a dovish Fed and a US Dollar in the coma. In the last quarter of 2012, Bernanke announced a further round of QE with monthly purchases totalling $85bn (of Treasuries and MBS) in order to boost productivity. This prevented the British pound of depreciating too much and raise interest in the cheap Euro at that time.

K. August 2013: New BoE Governor Mark Carney took office and the Pound experienced a fantastic year

In the summer of 2013, Marc Carney left the Bank of Canada to take over Mervyn King’s place as the new Governor of the Bank of England. Then, what followed was a series of good news and positive fundamentals in the UK; the British pound switched from the no-interest status to traders’ favourite currency (with the Euro, there were the market’s Darlings). Cable soared from its $1.48 lows to hit a 6-year high of $1.72 with market participants pricing in a sooner interest rate hike. Cable’s good driver of that one-year bull period was the increase in implied rates [looking at the short-sterling futures contract]. Moreover, Britain was the fastest-growing major economy in 2014, printing an annual growth of 2.9% (surpassing the US and its 2.4%).

L. Summer 2014: the Dollar wake-up and the start of a Bear currency market for the Pound

As I already wrote it in a previous post on the UK, the last positive words on the British economy came out of Carney’s mouth during a speech he gave at the Mansion House on June 12th 2014 (the same night of the kick-start of the World Cup in Brazil). He said that the UK was on a positive momentum (i.e. fundamentals were good) and hinted that the Bank of England may rise rates sooner than the market expected. At that time, I remember that the futures market was pricing in a 25bps hike by the end of Q4 2014.

However, everything vanished a few weeks later and more and more participants were starting to notice that the British pound was showing signs of ‘fatigue’ and that a consolidation was coming. In addition, May 2014 was also the announcement of the ‘Euro’s Death’ and that the single currency expected depreciation may spur an overall Dollar strength. And it happened… According to the DXY index, the Dollar strengthen by 25 percent against its main trading partners between July 2014 and March 2015. Cable tumbled from a $1.72 to $1.4635 during that same period.

In early 2015, most of the market participants was pricing in another 15 to 20 percent increase in the Dollar on expectations of the Fed starting a tightening cycle (taking the two previous Dollar Rally that we described earlier as empirical data: the Reagan Rally in the beginning of the 1980s and the Clinton Rally that occurred in the late 1990s).

2016: The Brexit effect and monetary policy divergence

After a brief pause in 2015 as the Fed halted its tightening cycle [due to the sharp sell-off that occurred in the beginning of 2016], Cable continued its bear market against the US Dollar in 2016 on speculation of a Brexit Yes vote first (in favour of leaving the EU), and then on the concretisation of the Yes vote (52% in favour of Brexit) following the referendum held on June 23rd. The pound traded below the 1.20 level against the greenback after the announcement, its lowest level in 21 years, and remains currently under pressure as Brexit uncertainty will continue until Article 50 gets triggered.

BoE answers to Brexit

After four years of status quo [and hints of potential rate hikes], the Bank of England announced a new round of QE in August last year targeting £60bn of monthly purchases (of which £10bn of corporate debt) and cut its Official Bank rate by 25bps to 0.25%. With the Fed now [seriously] reconsidering starting a tightening cycle after a first hike last month and three potential rate increase in 2017 (DotPlot Gradual Path), the monetary policy divergence between the US and UK and the political uncertainty in Europe (and UK) will weigh on the pound in the near future.

Chart 1. GBPUSD historical monthly candlesticks since 1971 (Source: Bloomberg)

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Chart 2a. Cable historical rate 1915 – 2013 

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Chart 2b. Cable historical rate since 1791

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Chart 3. UK Official Bank Rate (Red Line) versus US Fed Funds Rate (White Line)

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Image 1. Reserve currency status (Source: JP Morgan)

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Image 2a. UK Budget deficit in the 1920s (Source: ONS)

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Image 2b. UK Inflation Rate in the 1920s (Source: ONS)

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Image 2c. UK Unemployment Rate in the 1920s (Source: ONS)

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Image 3. US Annual Inflation in 1930-1939 (Source: BLS)

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Image 4. UK Current Account in the 1960s (Source: Trading Economics)

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Image 5a. US Current Account in the 1980s (Source: Trading Economics)

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Image 5b. US Budget Deficits in the 1980s (Source: Trading Economics)

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Image 6. US Dollar REER (Source: OECD)

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Image 7a. US Current Account in the 2000s (Source: Trading Economics)

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Image 7b. US Budget Deficits in the 2000s (Source: Trading Economics)

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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.

Macro 2: Euro update

After the first part on Japan, the second one will give a current status on the Euro Zone economy and the ECB. As in Japan and US, the deflationary cycle has also been a big issue (the annual HICP inflation rate has been moving around 0% over the past year) due to this commodity meltdown.

QE recap: As you know, Mario Draghi announced in January last year that the Central Bank will start expanding its Balance Sheet. The QE programme, called the Public Sector Purchase Programme (PSPP), started on March 9th 2015 and was first planned to last until September 2016. The purchases will be split between sovereign bonds and securities from European institutions and national agencies, and will amount a total of €60bn worth of bonds each month. As you can see it on the chart below, the announcement was quite a success if we look at the stock market; Eurostoxx 50 Index (candles) went up 28% between January 2015 low and April’s high of 3,836. At the same time, the programme also pushed down the single currency (green line) to 1.05 against the greenback, making the dream of certain EU’s officials come true.

EuroMarket.jpg

(Source: Bloomberg)

However, it didn’t take too long for the situation to change. The 10Y German Bund yield surged from a low of 4.9bps reached on April 17th to a high of 105bps on June 10th, a net change of 1% in simply 6 weeks. At the same time, the equity market went down 500 points and the Euro surged to 1.15, on rumours that the Fed will lose its ‘patience’ and start a tightening cycle and a weak and irreversible EMU. If we look at the moves on the interest rate market (European sovereign bonds and the single currency) since the famous meeting in May 2014, it is clear that the market’s participants had been front running Draghi on the basic rule of the ECB’s Will To Power. However, the two charts (especially the moves on the German Bunds) describe that this situation can change suddenly, drastically and very quickly.

GermanBund.PNG

(Bund 10-year, source Bloomberg)

In order to calm those market moves and restore a new bullish and stable trend in the market, the ECB’s answers were quite limited and combined a few promises (ECB ‘unlimited options’ jawboning, what does it really mean?), with a decrease in the deposit facility rate (from -0.2% to -0.3%) and an extension of the PSPP programme by an extra six months (until the end of March 2017). We saw that the market reacted negatively to those news and the EuroStoxx 50 Index trades now more or less at the same level (3,000  points) than in January last year (in order words, QE failure…).

When it comes to the Euro, there are a few things that fascinate me as it usually concerns more participants than its 19-nation economy. First of all, the chart below shows the deposit rate of the following countries’ central bank:

  • ECB at -0.3% (Blue/White line)
  • Sweden Riksbank at -0.35% (Yellow line)
  • Denmark at -0.65% (Red line)
  • Swiss SNB at -0.75% (Purple line)
  • Norway (Base Rate) at 0.75% (Green Line)

Deposit Rate.PNG

(Source: Bloomberg)

As you can see, all CBs switched to NIRP policies (expect Norway) over the past year to counter this deflationary cycle and sluggish growth; it seems that all other European economies (with Switzerland) have been forced to follow the ECB moves in order to avoid a sharp local currency appreciation (vs. the Euro). Therefore, when you hear about the ECB’s decisions, you must think what will happen to those economies as well (and some Eastern European ones as an extent). We will see what are the consequences and reactions in the near future (12 months) as we know that NIRP policies tend to inflate asset prices ‘artificially’, especially the real estate market (look at Sweden, or Norway for instance), and force banks to pass on the negative carry to their clients (questioning the value of money as it is better to hold money under the mattress than in a negative interest-bearing bank account).

Secondly, the Euro has been reacting positively (and violently) to a few market events, like the August flash crash (EURUSD surged from 1.1365 to 1.1714 in a single trading session on August 24th) or the Draghi’s disappointment on December 3rd (EURUSD went up by 5 figures that day). I am always questioning what can explain that? A first answer could come from the fact that the Euro has become one cheap funding currency, and during periods of stress, the carry unwinds lead to some Euro appreciation. It can explain some strength, but not sure about those drastic moves. Another explanation could be that sometimes, the Euro acts a safe-haven currency. I explained it a couple of articles (here and here), that we have to look at how the market is currently positioned (late correlation with the VIX index).

A quick EURUSD analysis:

At the moment, I visualize the Euro as a ball still full of air that everybody is trying to sink under water. However, everybody’s weight (which can be described as market participants’ view) can change and if it becomes too light, the ball can come up to the surface quite quickly naturally). The EURUSD-pair looks rangy; a strong support stands at 1.07 with a resistance area 1.10 – 1.1050 (100 and 200 SMA) where the bears are waiting to short. One careful thing to watch (and potentially play) is in the upside in case the 1.1050 level is broken; this could trigger many stops and bring the Euro to last year’s highs (1.14 – 1.16).

EURUSD.PNG

(Source: Bloomberg)

Macro 1: Japan and Abenomics

I will kick these series of macro updates by an analysis on Japan’s current situation. As you can see it on the chart below, the Nikkei index plummeted 14.50% since December’s high, hitting a low of 16,017 last week (20% drawdown from peak to trough). If we look at the chart below, it seems we entered a bear market in Japan and market participants could still consider the recent spike as quick oversold recovery.

Nikkei

(Source: Bloomberg)

The Yen also reacted to this market headwinds and USDJPY was pushed down to 116 last Wednesday (its August support). One thing that surprises me and captivates me at the same time is the correlation’s strength between all asset classes. For instance, if we look at the chart below shows the moves of Oil (WTI Feb16 contract in yellow) and the SP500 Index (Green line). The amount of pressure that the commodity decline has caused to the overall market is excessive and has put a lot of nations in trouble.

Yen and Rest.jpg

(Source: Bloomberg)

If we have a look at fundamentals, Japan seems to be in a liquidity trap. The BoJ’s balance sheet total asset has surged by 143% [to JPY386tr] since December 2012 and the central bank is currently purchasing 80tr Yen of JGBs every month. It’s has been almost three years that Japan is engaged into a massive stimulus programme, which hasn’t had the expected effect. GDP grew modestly by 0.3% QoQ in the third quarter (avoiding a quintuple-dip recession after a first estimate of -0.2%) and the core inflation rate increased 0.10% YoY in November of 2015, ending a 3-month deflation period but still far from the 2-percent target set by Abe and Kuroda. It is hard to believe that after all the effort (mostly money printing), the situation hasn’t changed much. The question is ‘what would happen if the equity market falls to lower levels and the Yen appreciated further?’ What are Japan’s options?

GDP.png

Inflation

(Source: Trading economics)

I remember one article I read last October from Alhambra Investment Partners, which was talking about the Japanese QE. The chart below reviews all the QEs implemented since the GFC and how the BoJ reacted each time it had a difficult macro situation (i.e. low inflation, stagnating equities, zero-growth…). As you can see, Japan has constantly increase its QE size little by little until Abe was elected In December 2012 and went all-in by starting its QQME stimulus on April 3rd 2013. As Ray Dalio said in many interviews (when he talks about the Fed), the effect of QE diminishes if credit spreads are already close to zero (and asset prices already ‘inflated’), therefore additional measures will constantly be less effective than in the past (‘central banks have the power to tighten, but very little power to ease’). I believe this is exactly where Japan stands at the moment, giving Abe (and Kuroda and Aso) a harsh time.

QEJapan.PNG

(Source: Alhambra Investment Partners)

Another BoJ’s important indicator is the Japanese workers’ real wages, which went back into the negative territory, declining 0.4% YoY in November and marking the first fall since June 2015 according to the Ministry of Finance. Despite PM Abe’s hard work pushing companies to increase wages in order to fuel household consumption, household spending dropped by 2.9% in November and has been contracting most of the months over the past 2 years.

HouseholdSpending.PNG

(Source: Trading economics)

With a debt-to-GDP ratio sitting at 230%, one chart I liked that was published in a Bloomberg post showed the ‘growing dominance’ of the BoJ. The central bank held 30.3% of the country’s sovereign debt (as of September 2015), more than any investor class. For instance, the chart below shows the evolution of the holdings of both the BoJ and Financial Institutions (ex. Insurers); at  the start of the QQME, BoJ holdings were 13.2% vs. 42.4% for Financial Institutions. How long can this story continue?

Holdings.PNG

(Source: Bloomberg)

 

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.

Quick update on the ‘Grexit’

Not only last year was a bad year for Greek market, Greece Athex is one of the worst 2014 performers (total return) with a 29% drawdown, but the country has suffered from political instability since the beginning of June. Since Syriza’s triumph in European elections on May 25th, the 10-year bond yield has soared from a low of 5.5% on June 10 to over 10% on ‘Grexit’ fears (the 3-year bond yields trading at 13.6%, up 10% over the past four months). The – Hellenic Republic – 5-year CDS, a good measure of the country’s default risk, is up more than 1000 bps, now trading around 1500bps. There has been some speculation of a possible ‘Grexit’ scenario; and as Der Spiegel news reported lately, German Chancellor Merkel is ‘prepared to let Greece leave the euro zone’ if the country abandons fiscal discipline and does not repay debts to its creditors.

2015: another difficult year for Greece

This year, according to Nomura’s analysts, Greece will face total payments (Principal + Interests) of 22.3bn Euros; €8bn scheduled to be paid to the ECB (mainly in July and August). As you can see it on the chart below published by Eurostat, which shows EuroZone debt and deficit by country, with a debt-to-GDP ratio standing at an all-time-high of 175% (despite the debt ‘haircut’ back in March 2012) and a deficit of 12.7% in 2013, there is no doubt that the country’s debt is unsustainable.

EZfiscal(Source: Eurostat)

There is nothing to stop it growing except haircuts, i.e. ‘partial’ default. Even though Greece’s recession has ended last year after almost six years of misery (the economy is now 30% less than in 2008), financial conditions (unemployment rate at 26% in total and 50% for youth, deflation for the past two years) will weigh on the economy longer than many analysts expect, especially now with the global macro conditions.

How strong is the anti-austerity party in Greece?

To sum up briefly the events of the past few weeks, Greece failed to approve a president (Stavros Dimas) nominated by PM Antonis Samaras as the number of votes didn’t reach 180 after three consecutive rounds (in the last round, 168 Greek lawmakers voted in favor of Dimas, 132 against). Therefore, as the Parliament failed to elect the President, Greek Constitution provides that the Parliament is being dissolved and snap earlier elections.
Greek elections will take place in a couple of weeks (on January 25) and the question is What could it look like?

In the last days of 2014, I remember that a first poll done by Alco for Proto Thema suggested that no party will have a clear majority in the new parliament (as one party will need roughly 35% of the Greek votes in order to gain an absolute majority). At that time, Syriza, a leftist anti-austerity party led by Alexis Tsipras, was ‘leading’ the league with 28% of the votes, followed by liberal-conservative New Democracy (ND) with 23%.

The market’s reaction was quite brutal as I said earlier as many investors fear that Greece may be forced to leave the Euro. The Syriza party wants to abandon the austerity measures imposed by the Troika as part of the €240bn bailout and wants a writedown on the nominal value of Greek Debt. I like the chart below (Source: Bloomberg) that gives you an idea of the government exposures to Greek’s public debt. The main bloc is held by official creditors (Euro-area governments: 62%; followed by the IMF, 10% and the ECB 8%). As you can see it in the chart, Germany is the major government-creditor of Athens and has more than €60bn in total exposure.

GreeceExpo(Source: Bloomberg Brief)

Greece bank shares (Alpha bank, Piraeus) all collapse over the past few weeks as fear of bank solvency and bank runs surged (Cyprus ‘bail-in’ regime continental template?). As a matter of fact, interruption of liquidity by the ECB to Greek banks will potentially lead to a ‘Cyprus type’ bank holiday.

Latest update: An article from the WSJ came up earlier this morning, and says that in nine separate opinion tools that were published in the Greek media in the last couple of days, Syriza is still on top and would garner ‘between 27.1% and 31.2%’ of the votes.

ECB meeting and consequences on the Euro.

As we know, any spike in Euro peripheral (or core) bond yields has usually bad consequences on the single currency. Even though Greece doesn’t represent a major risk for the 19-nation economy, I strongly believe Greece is and will be the ‘hot’ topic of the next couple of weeks (with the Yen as usual). And at the moment, Greece makes ECB policymakers’ life complicated, concerning the central bank’s introduction of its public QE in order to counter deflation now (yes, you read it, deflation of -0.2% in December).

EUR/USD broke its 1.20 psychological support earlier this year and is now trading slightly above 1.1800 (a 9-year low). The next support that traders will target now stands at 1.1640, which corresponds to 2005 low.

I don’t think the market will react aggressively at the next ECB meeting on January 22nd, and even though we don’t hear any update concerning its QE, the Euro is still capped on the topside. I added below a timeline from Morgan Stanley that sums up the Key risk events for the EZ this quarter.

EZrecaps(Source: MS Research)

Below is another chart posted by SG Research that shows the ‘global macro’ euro are agenda for January and the downside/upside risk scenarios. As you can see, it includes the (forgotten) OMT case with the European Court of Justice’s decision on the legality of the ECB program for sovereign bonds.

SGEZ

(Source: SG Research)