Saturday, January 05, 2013
Before moving onto our first Non-Prediction of 2013, TMM thought they probably should at least comment upon last week's moves in fixed income markets which appear to have caught a lot of people off guard. The FOMC minutes suggesting that QE3 could end by the close of this year evidently surprised a lot of people. TMM were lucky enough to have been short various rate markets, but covered these on Friday morning ahead of Non-Farm Payrolls. The spike higher in yields has been very rapid and reasonably large - justified to some extent by the passing of the fiscal cliff deal and generally stronger data, but things do not move in straight lines.
There are some strong underlying currents developing at the moment with govvies looking as though they have minimal upside globally, equities showing their strength as alternatives to highly complex and margin tight credit products and reflation trades in general showing their mettle (pun intended) and the post FOMC reaction was like a small "no more QE" earthquake shaking them. Bonds were swiftly shaken lower, equities got shaken down against trend and USD/JPY was accelerated on its path. TMM would normally look for opportunity to buy things that have been shaken back against trend in such events (equities in this case), but some things have moved so far forward of where they should be right now we are looking to go countertrend.
The fact that things like Schatz & Euribor have also sold off to the extent that barely any chance of a further deposit rate cut is priced in has TMM reckoning that buying things like ERZ3 or ERM4 ahead of the ECB meeting represents compelling risk/reward. Additionally, seemingly in contrast to the theme of our first 2013 Non-Prediction, TMM purchased some 1 month 86-strike USDJPY puts on Friday, for a cheap-looking 33bps. Given the parabolic nature of the recent move and weekly RSIs being as overbought as they have been since 1997, the setup for a countertrend move early next week looks good. We also appreciated the market reaction to an "as expected" NFP which gave strong clues that expectations vs. reality are ahead of themselves in the very short term.
And finally... on to our first Non-Prediction of 2013:
1) Japan will NOT escape deflation this year, but reflation trades will NOT disappoint.
TMM have generally been skeptical of these kinds of trades, given that people have been trying them for the best part of 15 years, and especially over the past couple of years, with little or no luck. But, as regular readers will know, TMM changed their minds in recent months (sadly missing the most recent moves from mid/late-December, but booking a tidy profit so we shouldn't complain) for two main reasons:
First, the Basic Balance of Payments (see chart below from GS) has failed to recover from its post-Tohuko earthquake deterioration, instead remaining mired in deficit. On the trade side, the nuclear plants haven’t been switched back on (much to TMM's surprise - though the poor showing of the anti-nuclear parties in December's election & subsequent TEPCO rally as the Keidanren are de facto calling the shots now probably means some reversal of this position), territorial tensions with China have hit (especially) auto sales and Japan Inc. is being hollowed out by Korea (TMM bought a new laptop in the sales, with an equivalent Samsung spec being as much as £400 cheaper than their hitherto trusty Sony Vaios - it wasn't a hard choice...). The experience of the UK over the past 10 years suggests that once lost, it is very difficult to regain market share, even after FX depreciation.
The other main component of Japan’s Current Account is the Income Balance, which sits in hefty surplus. The problem here is that maturing bonds are being reinvested at poor yields, which threatens to structurally weaken this component going forward (even after considering Mrs. Watanabe’s recent flirtation with the Turkish Lira). It appears that the deterioration in the BoP has become structural.
Second, there has been a dramatic change in macroeconomic policymaking within Japan over the past year. The BoJ adopted a 1% inflation target and began expanding its balance sheet at a pace it has historically resisted. But it has still opposed being as aggressive as the Fed, with Governor Shirakawa repeatedly arguing that monetary policy cannot do anything to get out of deflation. The recent election, however, with a super-major for the LDP-led coalition, changes all of this given that the central theme of election campaign was the call to institutionalise a 2% inflation target for the BoJ and to embark upon aggressive policy easing (both monetary & fiscal). TMM cannot imagine an election in the UK or US being centred on such a specific monetary policy framework - the closest parallel really being the UK's 1979 election & the embrace of monetarism. TMM cannot remember political pressure upon the BoJ ever being so great, with explicit threats to change the BoJ Law if they don’t play ball. This is doubly important given Shirakawa’s term expires in March and it seems likely that the academic Iwata san, who is known to favour aggressive easing. Press reports suggest the BoJ have accepted the government's will.
Of course, the Nikkei & Yen have moved quite a lot already, but they can certainly move a lot more. When the deleveraging cycle in Japan ended in 2005 (see chart below) we were given a hint of the potential for reflation trades, as the Nikkei rallied 60%, the belly of the curve sold off 100bps and USDJPY rose 15%. And exit from deflation still looked years away. Then, as they often are prone to do, the BoJ torpedoed everything by ending QE and then moving to hike rates. If policymakers are pushing in the right direction and the BoJ don’t about turn and crush the reflation, things can go a lot a further.
Can policymakers raise Japanese inflation expectations towards 2%? Well, it’s a tough shot, but the evidence from the US & UK is that if central banks are aggressive enough, they can move inflation expectations to where they want them (while nominal yields have fallen over the past few years, whenever forward breakevens have moved too low, monetary easing has followed). TMM are in the camp that believe the BoJ have just not tried hard enough before.
As far as USD/JPY goes, we all know the Yen is overvalued as far as PPP/REER metrics go, but the bulk of the reason for the move of the past 5 years is the dramatic fall in real rates in the US, which for the 10yr is now something like -65bps (up from around -90bps in mid-December). Stitching together linkers & inflation swaps (not perfect, but good enough for this back of the envelope exercise), Japan has been stuck with 10 year real rates in the 1-2% range in the face of the Fed moving those in the US down from 2.5% to -0.9%. The flip side of real rates being so relatively high (despite low nominal JGB yields) is that inflation expectations in Japan sit at just 0.50% for 10 years. Still, since introducing their 1% inflation target earlier this year, the BoJ have at least managed to get these positive (having been showing continued expectations of deflation beforehand) and also to move long-term real rates to the lowest they have been since at least 2005 (see below chart).
The chart below shows the 10 year real rate spread between the US & Japan (blue line) vs. USD/JPY (red line). It also shows a few scenarios for what could happen (assuming that US inflation expectations remain unchanged at current levels). The bear case (light blue line) shows a projection of the spread if 10 year Treasuries are largely unchanged from their end-2012 levels (1.75%) by the end of December 2014 and the BoJ is unsuccessful in moving inflation expectations higher than current levels. In this case, USD/JPY is likely to move back towards 82, not a disaster. The Stable Bonds case (purple line) assumes that the BoJ are able to move these as high as 1%, but overall bond yields do not change (presumably the function of continued aggressive easing and tepid growth globally). A gradual move towards 90 for USD/JPY can be expected in this outturn. TMM's base case is that US growth reaccelerates as Euro-contagion becomes less of a driver of markets & the CapEx cycle ramps up, sending 10yr yields towards 3% by the end of 2014 (driven by a 125bps move higher in real rates). In this case, the BoJ are partially successful, getting inflation expectations up to 1% and targets USD/JPY at around 110. Finally, the bull case is both a re-acceleration of the US resulting in 10 year yields pushing 3% by end-2014 *and* the BoJ are successful in moving inflation expectations up to 2%. This would send USD/JPY back to levels not seen since 2007.
However, the rapid acceleration to the topside in USDJPY (outperforming the real rate move so far) since mid-December has TMM hoping for a pull back before dipping back in again (it's kind of hard to buy something when the 14 weekly RSI sits at its highest level since February 1997...).
What about JGBs?
Well there’s not really much to be said other than shorting JGBs has been a graveyard trade. But should the BoJ manage to reflate the economy then it is not too much of a stretch to imagine with 1% growth + 2% inflation that medium/long-dated forwards should be trading around 3%. The long end (10Y10Y and 10Y20Y) have already moved towards this level – but then, they have traded these levels before when reflation hardly looked imminent. Should the BoJ gain traction, the 10yr sat at just 0.7% looks very vulnerable and there is plenty of room for the 5Y5Y forward to move higher. The risk reward to shorts here, with so much BoJ easing priced in to the curve strongly favours selling JGBs, though TMM reckon after the move lower in fixed income globally the past week, we get better entry levels. After all, if the BoJ are successful, yields will move sharply higher, if they are not, the negative carry is only around 18bps/year with a move to the 2003 deflationary panic lows of 41bps (which seems exceptionally unlikely given the BoJ are easing aggressively and there is no NPL/Resona bank shock right now) wiping out a further 30bps.
And the Nikkei/Topix?
Well, with the recent rally, the forward P/E has already expanded from around 12.5x to 15x, which isn't exactly cheap, so buying upside here has to be a function of EPS growth. Which means it is going to be a function of how much the Yen weakens (as far as exporters go), but also the extent to which raising inflation expectations spurs domestic demand. The below chart shows a model of the one year ahead EPS of the MSCI Japan based upon the Yen, the Tankan, ISM, Core CPI & M2. Using relatively conservative assumptions for these variables produces an EPS number of around 44.9. With the index trading 549, this produces an earnings yield of around 8.2% (or 12.2x 2013 earnings). That looks cheap enough to want to own some, but again, given the recent moves, TMM are hoping for some retracement to allow them to get back in.
So that's the theory behind the first of TMM 2013's first Non-Prediction. A little more drawn out than in past years, but the Yen theme needed a more detailed post as we haven't done it justice since it hit No. 1 in the "Trade Parade" over the past few weeks. More non-predictions to follow in the next few days.