Saturday, January 05, 2013

2013 Non-Prediction No.1

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.


amplitudeinthehouse said...


Over the festive break amps found himself in the middle of an existential trading paradigm, and as you do with any existential related issue you give the Matrix Trilogy a re-run. Dark sun-glasses within arms reach when deciding to leave the confines of a darkened environment that complements your motivation for the journey that lays ahead before hitting the pause button and walking out into the street between enlightening moments and trying your hardest to assimilate the ineffable perceptions and feelings within you to the local environment, only to quickly feel the surrounding void push you back into questioning that splinter that still sits in your brain asking over and over ...why?

Well that why question comes after breaking down our Macro and Trend Following books and finding the trendfollowing system won out easily , and even more so compared to notable Trend Following shops...

As for the Macro trading , Last year we noted three key indicators to watch

China stimulus

Euro intervention

Multiple PE expansion in the SP500

given all three eventuated along side USA QE ^ and having the macro synapses metamorphosed from the racing fundamental matrix to global macro fundamental trading matrix since the beginning of the QE Matrix in 2009 it was not too difficult to decide not to implement an short risk strategy and more of a standaside strategy apart from picking a couple tops throughout the year when a couple leading indicators were obviously being used by the HFT machines.

With the Yennish put implemented globally in many “forms” not naked to the eye , the question for me in 2013 is do we extrapolate or contrast?

Every beginning has an end ,the Oracle said, but the Architecture in 2012 implemented QE infinity to a employment and inflation matrix that he can adjust to any level of his choosing... within an economy that is below trend of growth ,any guesstimate is an illusion due to an interchangeable third variable that shall not be speaked withn the matrix unless of course you’d like 500 agents on your tail.

We’re confident the gamechanging QE matrix implemented in Europe makes it primordial appearance in 2013....and with a USD currency swap sitting in the chair waiting to enter the simulated reality, you really do have to BELIEVE if you are to trade against the Euro at lower level s we’ve already seen.

The China collapse at this stage is not mathematically possible , remember if numerology is only an abstraction of the senses then within the QE matrix the binary code has taken on a life of it’s self, slithering and feeding as it travels through our void into our innate anachronism thats’ taken on a new paradigm in the QE Matrix..

If we are to believe Telos is still alive an well in the world ,than extrapolating the previous QE years is a no brainer , and at worst the risk on trades KEEPS staggering up until we arrive at previous epochs in the market that are analogous to the dialogue between Neo and the Oracle sitting in the park on the bench..

Bullish punter : Why am I here if I’ve already made a decision

SP500 : You're just here to find out why you made that decision..

amplitudeinthehouse said...

The other pill we can choose to pop is the contrasting element.

One that can be weighed and contrasted is the dialogue of the CBankers with the Global-macro trend environment and adjust for risk premiums , which, within the Architecture of the QE Matrix ,once certain thresholds are breached in individual phenomenal markets, we can be sure the circulatory efficacy of the machines to be enviable.

The margins debate is a contrast variable that we admit has surprised us with it’s ability to maintain its record level...but contrasted once again with commodities and the previously mention ongoing structural developments in the employment sector this can not come as a surprise within the backdrop of low rates.

Currency wars are alive and well in the world.IF I was to say that what we’ve seen is only the start of a major calibration in the foreign exchange matrix, would you bet against me ? what direction does that put the US dollar in ?

Prediction 2013.....Haven’t got a clue!

But we do know we’ve come the last of our dialectical mysteries . In 2013 do we transmogrify into Morpheus the Macro Strategic Trader that never sleeps or Leo the limit order down the pub Trendfollower ? because we don’t plan on spending 2013 like 2012 …...

…..Trinity, pop in that sential program that I whispered in your ear last night..

comment maigrir said...

I am really worried about this

Anonymous said...

DD doesnt fancy chasing buses either. That said looking back at that 2005 run, there werent many retracements along the way. So many U/W Japan, there is probably plenty of room for dips to be bought promptly. We'll see.

(On a sidenote, our roman friends may have stolen the show, but amps' weekend rants are an underrated pleasure of the comments section).

Leftback said...

Amps certainly seems Amped up for 2013. If Alan Greenspan watched the Matrix a lot, his post-FOMC utterances would have been even more entertaining.

LB finds himself bored this week, especially so now that he no longer has a terrifying amount of VaR. We have found that the first week of earnings season in the US is: a) often a head fake and/or b) a bit of a snoozer.

So while we are generally still quite optimistic, especially about China and Europe, it seems like a good time to sit and watch for a few days while perusing charts and reading what the data crunchers in the blogosphere have to say, or even indulging in Macro Guilty Pleasures, a bit of stock-picking.

There does seem to be a modest amount of irrational exuberance in the market, but it is largely confined to a few stocks that sport P/Es in the 100s (social media) or have recently gone parabolic (homebuilders) due to over-eager shorts being rudely treated. So we did pick up a few small positions betting that FB, LNKD, HOV, PHM and KBH are probably not going to defy gravity for ever.

Leftback said...

Here is a fantastic ten year chart. Homebuilder LEN peaked above $60 in 2005. During the 2005-2008 period it had a solid base around $40-42, before collapsing to below $5. In 2012 LEN rose from below $20 to $40. The stock is closing in on that $41-$42 zone right now..... hmmm

Homebuilders Going Parabolic

globalmacrotrading said...

Great post. Enjoyed it very much. Here's a rebuttal of sorts, if you care:

langone said...

I like the rebuttal better. Too many 'short yen, innit?' muppets suddenly. Time to slaughter some piggies.

Anonymous said...

Mark Dow's latest is well worth a read. Too much complacency about how inefficient monetary policy is, he reckons (basically the liquidity trap concept has gone from minority opinion to consensus over the past three years).

Looking at it from the credit angle, there is certainly some truth to this (you only need to watch some of the dogs of 2008 to see that policy IS working, despite this not being observable everywhere because of broken transmission yada yada yada).

Given current positioning, I wouldn't be surprised if things unfold much much faster than it takes for policy transmission mechanisms to be fully restored.

- DD

PS: for the new yahkers out there, my captcha reads "61 nyMARIS". Monkeys, typewriters and Hamlet indeed.

Leftback said...

USD and JPY a bit stronger today. Strength in USTs reflecting a week full of POMOs and some anxiety about upcoming earnings?

This is usually the prequel to a little bit of piglet slaughtering in equities. EURJPY has had an amazing run from 101ish to 116. A retrace of that move might target the 107 area. Even that large a move should not be catastrophic for European equities unless the USD also makes strong gains at the same time.

langone said...

shorted some PHM myself

Leftback said...

USDJPY retrace is in full swing, wondering is the March high of 84 too obvious a target? That might cause a bit of pain for equities (esp. the Nikkei which has become a leveraged yen carry trade), but a somewhat weaker dollar would work better for commodity currencies, US exporters and EM equities to some degree. Perhaps down to the lower end of the recent DX range?

LB is looking at Brazil being "really" hammered on inflation fears and wondering about those gloves....

No rush, let's let the silly season of first few earnings play out and watch the FX moves in the background.

Anonymous said...

More to go possibly (perhaps this wont be the 2005 hockey stick after all). Eyeing FXY 119-120 and N225 sub 10k.

On a sidenote, the credit reflation doubters should have a look at TWO, CIM and the likes. Steady ramps unfolding there.


Anonymous said...

C Says'
Perhaps I am missing something in my makeup ,because I am mystified.
Seem to have a series of calls for counter trend JYen. Now we know this crowded and on that score you might want to bank some profit as you go towards targets of 90 level ,or even into the key date 22nd Jan. Yet a chart gives you no reason to try to be counter trend other than it's been assuming a parbolic shape as it goes and they can certainly end with a blowoff hence you don't want ot be still riding a full position at that point. But counter trend with nothing to no price action to tell you you are yet at that point?
Perahps you chaps have access to soemthing I don't if so I err.

macrottt said...

Hi TMM...
I am a newcomer in this forum, but I am a long time reader.
I just wrote a piece on the USD/JPY and what puzzles me in the JPY trade.
(see: )Particularly:
1/ the lack of structural reforms to deal with deflation (due to ageing),
2/ the lack of confirmation move by either JGBs or Treasuries (signaling massive QE),
3/ the low likelihood that the US or the EU would tolerate unsterilized govies purchases by the BOJ,
4/ the scary side of Abe and its cabinet in foreign policy and their total lack of reform background.
If you have time, I would be happy to have your views on these 4 points. Rgds.

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