Q: What do you get when you dress a pig in a prom dress?
A: A pig.
Macro Man has been trousered by one of the fundamental errors in macro investing- the dreaded proxy trade. His calls on the US equity market, while not perfect, have been pretty good, yesterday’s rally notwithstanding. However, by trying to hedge via proxies (particularly currencies) and being cute with a calendar spread instead of straight puts on the S&P 500, he has borne all the losses incurred by US equity weakness (via the beta plus portfolio) while losing money on his hedges at the same time. Memo to self: if you want to dance with the prom queen, it’s best to avoid the barnyard.
Macro Man has stopped himself out of the short AUD/CHF position at 0.9705 spot basis (0.9690 to 04 April.) While equities remain firmly ensconced in the danger zone, risk/carry currencies have broken all manner of resistances. The Indian rupee, for example, is now trading at its strongest level against the dollar since late 2005, despite the fact that the SENSEX chart continues to look awful. India is one of those weird stories that people either love or hate. Macro Man wants to hate it (current account deficit, lots of hot money inflows, unionized workforce, etc.) but concedes that the price action is more love-worthy. As such, he stays away. Meanwhile, current losses on the SPY position are somewhat exaggerated as the ETF went ex-div last Friday, knocking $0.55 off the price. The dividend will be reinvested back into the portfolio when it’s paid on April 30.
Now what might you say about the currencies of those five countries?
Country 1: Has historically been cheap, might now be expensive as deficit is turning
Country 2: Doesn’t look out of whack as deficit is steady
Country 3: Dirt cheap
Country 4: Pretty cheap
Country 5: Ebbs and flows between cheap and expensive; had been cheap, now might be expensive
What if we present the data another way? The chart below shows the five countries’ share of the US trade deficit, because after all, a $5 billion deficit in 1987 ain’t the same as a $5 billion deficit in 2007.
Hmmm. The most interesting change here is country 2, which has seen a steady and steep deterioration in its share of the US trade deficit for 15 years. While it has lost most of its share to country 3, on a trend basis it has lost ground versus each of the other four countries for the past 10-15 years. It’s not exactly a compelling argument that the currency of this country is fundamentally super-cheap, is it? Yet that is an argument that is taken as practically gospel amongst most of the analytical community, for country 2 is of course Japan. The full roster is as follows:
Country 1: Eurozone
Country 2: Japan
Country 3: China
Country 4: Mexico
Country 5: Brazil
Of all the arguments in favour of ‘global decoupling’ and Japan, this one is probably the most powerful...but it’s one that nobody makes because it contradicts the conventional wisdom that the JPY is uber-cheap!
A: A pig.
Macro Man has been trousered by one of the fundamental errors in macro investing- the dreaded proxy trade. His calls on the US equity market, while not perfect, have been pretty good, yesterday’s rally notwithstanding. However, by trying to hedge via proxies (particularly currencies) and being cute with a calendar spread instead of straight puts on the S&P 500, he has borne all the losses incurred by US equity weakness (via the beta plus portfolio) while losing money on his hedges at the same time. Memo to self: if you want to dance with the prom queen, it’s best to avoid the barnyard.
Macro Man has stopped himself out of the short AUD/CHF position at 0.9705 spot basis (0.9690 to 04 April.) While equities remain firmly ensconced in the danger zone, risk/carry currencies have broken all manner of resistances. The Indian rupee, for example, is now trading at its strongest level against the dollar since late 2005, despite the fact that the SENSEX chart continues to look awful. India is one of those weird stories that people either love or hate. Macro Man wants to hate it (current account deficit, lots of hot money inflows, unionized workforce, etc.) but concedes that the price action is more love-worthy. As such, he stays away. Meanwhile, current losses on the SPY position are somewhat exaggerated as the ETF went ex-div last Friday, knocking $0.55 off the price. The dividend will be reinvested back into the portfolio when it’s paid on April 30.
Switching gears, there was an interesting discussion over at Brad Setser’s blog the other day about whether exchange rates matter for external balances or not. Now, Macro Man has previously contended the modest nature of Japan’s trade surplus (by historical standards) suggests that the yen is not as undervalued as many commentators appear to believe. Macro Man decided to dig a little deeper. The chart below illustrates the one year moving average of the US bilateral trade deficit with five unnamed countries. They can best be described as follows:
Country 1: 15 year deterioration that is finally showing signs of improvement
Country 2: Broadly stable trend with a tilt towards slight deterioration
Country 3: The world’s most populous country
Country 4: Steady trend of deterioration over the past 15 years
Country 5: Trends around zero, deficit appears to be improving
Country 1: 15 year deterioration that is finally showing signs of improvement
Country 2: Broadly stable trend with a tilt towards slight deterioration
Country 3: The world’s most populous country
Country 4: Steady trend of deterioration over the past 15 years
Country 5: Trends around zero, deficit appears to be improving
Now what might you say about the currencies of those five countries?Country 1: Has historically been cheap, might now be expensive as deficit is turning
Country 2: Doesn’t look out of whack as deficit is steady
Country 3: Dirt cheap
Country 4: Pretty cheap
Country 5: Ebbs and flows between cheap and expensive; had been cheap, now might be expensive
What if we present the data another way? The chart below shows the five countries’ share of the US trade deficit, because after all, a $5 billion deficit in 1987 ain’t the same as a $5 billion deficit in 2007.
Hmmm. The most interesting change here is country 2, which has seen a steady and steep deterioration in its share of the US trade deficit for 15 years. While it has lost most of its share to country 3, on a trend basis it has lost ground versus each of the other four countries for the past 10-15 years. It’s not exactly a compelling argument that the currency of this country is fundamentally super-cheap, is it? Yet that is an argument that is taken as practically gospel amongst most of the analytical community, for country 2 is of course Japan. The full roster is as follows:Country 1: Eurozone
Country 2: Japan
Country 3: China
Country 4: Mexico
Country 5: Brazil
Of all the arguments in favour of ‘global decoupling’ and Japan, this one is probably the most powerful...but it’s one that nobody makes because it contradicts the conventional wisdom that the JPY is uber-cheap!
8 comments
Click here for commentsI am not a big fan of taking bilateral trade deficits as a % of the total, since that misses the fact that the overall deficit is increasing. Oil fluctuations also influence the total and thus countries share. The shift in electronics final assembly toward the rest of Asia -- along with the growth in Japanese auto production in the US -- both worked to lower the Japanese bilateral surplus. But only the shift in auto production seems to have had a big impact on Japan's overall current account surplus (and the US deficit) from say 87 thru the early 90s. Then japan's slump kicked in and started to drive the data.
ReplyI think what this analysis perhaps misses is the recent growth in Japan's current account surplus, and especially the growth since say 04. Over much of the period in your charts, the yen was sort of strong (up til 95) and even in 02-04 it strengthened v. the $. The impact of say post 05 yen weakness is only now being felt, given various lags (japanese export growth has been pretty good) and in 07 export performance may not be offset by a rising oil import bill, so the rise in the trade surplus may be stronger. Plus the income surplus is rising -- and that matters for a country with Japan's large net foreign asset position - over time, one would expect the positive income surplus to finance a japanese trade deficit.
but it also fairly clear at least to me that the big populous country is rather more undervalued than the yen, no matter what one popular london opinion magazine claims!
bsetser
The reason I looked at bilaterals was to strip out the impact of energy, as obviously neither Japan nor the US is an energy exporter!
ReplyWhile this analysis obviously does not "prove" anything about Japan or the yen, I think it is a significant thorn in the side of any claim that USD/JPY is 30% overvalued or some such, which a number of people do make. If it were, then surely there would be a more significant deterioration in the bilateral deficit compared with, say Europe- especially given the rather poor state of Japanese domestic demand during the last 15 years.
And while Japanese offshoring production to the US is a mitigating circumstance, many European automakers have done the same thing, which hasn't detracted from the growth in the deficit with EMU. Moreover, surely there is a currency valuation view implicit in the decision to export production (though in the case of the Japanese automakers, there is clearly a political element involved as well.) Finally, the same argument could be used to the nth power in discussing the US deficit with China!
On the income issue, yes it suggests that trade does not tell the whole story. But of course, a very substantial minority of the income derives from coupon-clipping on FX reserves, which obviously may not have the same currency impact or implication as if it were dividends on private equity stakes, for example.
Not, repeating Brad's comments (re: energy distortions and & bilateral as % of tot) which I agree with, I think you should stand your thesis regarding relative YEN cheapness/dearness on its head and ask "Why should a country such as Japan set official rates of discount at levels as absurdly ridiculous as they are in relation to other OECD peers?
ReplyFor whatever apologists say, adjustment within large deficit countries would be more meaningful, and global FX and IR markets less distorted, when imbalances are converging towards some intermediate equilibrium rather than diverging from it. Moreover, normalization will go a long way towards insuring capital stops flowing uphill for political expediency, rather than as a result of economic rationality. See Woods & Reading call to normalize in the Bloomberg link or in CLSAs Fear & Greed.
The original starting point of the analysis (which I concede was not really communicated much if at all in the post) was the 'do exchange rates matter?' issue on Brad's blog.
ReplyBrad posted some charts that I thought perhaps overstated his case, and drilling down on an individual country basis would appear to support that view.
Is the yen undervalued against the dollar? Yeah, I think it is, but by a small amount- I reckon it was overvalued by a similar magnitude in early 2005. Nothing in the trade numbers suggest to me that that is off base.
Is the yen undervalued against the euro? In the view of just about everybody, including me, absolutely. I reckon fair value for EUR/JPY is probably 120-125, a level the cross has comfortably exceeded for 3+ years. Yet only now is Japan showing any signs (and they are as yet modest) in gaining net export share in a highly significant third market, the US.
Vis-a-vis imbalances, I would broadly agree with you. My focus, however, is on the marginal driver of imbalances, which are the FX reserve accumulators.
I find it difficult to chide the Japanese policymakers too much when it is an (understandable) stock adjustment of household balance sheets that is driving capital exodus.
The BOJ is, or is being pressured to, pursuing a Maximin strategy...i.e maximizing the utility of the worst case outcome. In the case of Japan, that means avoiding a relapse into the dark ages at all costs. If the outcome is a bit of asset price inflation (consumer price inflation being strangely AWOL)...well, so be it. While Fukui may not prefer this strategy, he is clearly on the receiving end of a substantial amount of political pressure to pursue it.
One could, I suppose, castigate the MOF for instigating moral hazard via the 'MOF put' in USD/JPY. However, if there is an equivalent 'MOF call' struck at 125 or 130 (I suspect the latter is more likely), then I don't really have a huge problem with it. We'll only know if such a call exists, however, once we get there!
Just a quick note on INR strength. Most of the strength is on account of a local long INR positions. It is tax season, corporates have to make large INR pmts. and the money mkt is very tight as bank credit/deposit ratios are stretched (still large lending to pvt sector that continues to outpace deposit growth). So corporates try to borrow in repo mkts. But even here due to the 'Statutory Liqudity Ratio' -basically a mandate to keep 25% of assets in govt securities- liquidity is tight because there is little/no excess govt assets over the SLR (due to high pvt credit growth). So corporates have scrambled to the call money mkt, where overnight rates shot up, and led to a sell-off in $ holdings for more rupees (hence the sudden $ weakening).
ReplyFrom a policy perspective, the RBI can either not sterlize inflows to prevent such liquidity gridlocks (this is obviously not good for its inflation fighting effectiveness or credibility), or the SLR ought to be brought down. SLR reduction is on the cards, it just needs to be passed into law and is expected to happen soon.
SLR reduction will also be aided by consolidation of fiscal deficits (combined central+state govt deficits are trending down steadily). So in all, I expect a structural improvement in money makets, and a stabilizing impact on the INR. The wildcard here is whether, or to what extent, the RBI will be successful in reining in pvt credit growth.
Anyways, thats it. Just a quick note to share some thoughts on the causes of the recent INR strength.
That's great info, thanks. Do you know when the deadline for tax payments is?
ReplyCheers
macroman -- any thoughts on the Koll/ Merrill analysis, which challenges the argument that household balance sheet adjustment has been driving capital outflows from japan/ yen weakness? (Koll says the real culprit is foreign banks borrowing in the interbank market in tokyo for their HF clients)
ReplyAs for my analysis, I looked at all of Asia to try to address the "China surplus is growing but it is just coming at the expense of others in Asia issue" -- i can try to do a more disaggregated analysis (I think Korea v. Japan might be interesting, as the won has strengthened v the yen/ yuan and the export electronic components to China for export to the US factor is at work for Korea as well). I generally try not to slant the data toward my case -- at least not too overtly ...
I agree tho with your point that the yen's unattractiveness as a reserve currency is an important source of yen weakness. and if you have any thoughts on how China's various plans will impact the market, do chime in on my most recent post. cheers.
brad setser
Ha. I think I was posting on your site while you were posting here.
ReplyThe only data I have been able to find on foreign bank borrowing/lending yen is pretty nebulous. I am not sure if it shows foreign bank lending in yen to offshore counterparties, or foreign bank onshore borrowing of yen (presumably to then lend offshore.) I can only find the data in Datastream, not the BOJ website (even though the data is from the BOJ.)
Regardless, the data, for what its worth, does not suggest that the carry trade as perpetrated by gaijin is what it used to be (although it has ticked up significantly over the past couple of years.) I first posted the chart in the 'return of serve' post:
http://macro-man.blogspot.com/2007/02/return-of-serve.html
(As an aside, if anyone (Cassandra?) knows how to link directly in the comments section, please tell me how!)
Japanese lifers' hedge ratios are also something not captured in any official data; these are a function of hedging cost (which has risen substantially over the last 2-3 years) and market view (they are happy to participate in a yen weaknening trend.) I know of no data set other than individual bank flow series that capture this phenomenon. And one bank, Citigroup, has had the 'wall of money' leaving Japan (via Japanese investors) as its single biggest flow theme for the past two years.