That’s it yen

15 Mar @ 08:19

The yen is off some 1.8% vs. the dollar so far this week, with USD/JPY touching an 11mth high in recent days. There have been been a lot of changes in FX dynamics so far this month (see below), of which the yen has been just one. The better tone to US data has certainly been playing a part, but there’s also the concern that Japan may be starting to struggle to maintain its net creditor position as the trade balance deteriorates but also as the population dynamics erode the nation’s savings position gradually over time. This has created some larger structural fears for the yen, which have been present over recent months and years, but wider global forces have served to keep the yen strong, not least the currency’s perceived safe-haven status during times of trouble. If these headwinds (better US data, reduced fears of contagion in the eurozone) continue to abate, then there is a stronger case for suggesting the days of yen strength may be over.

Commentary

FX effects. We’ve seen a stark shift in FX markets so far this month, a telling indication of both valuations and risk appetite. That Greece has avoided default, the ECB has thrown more 3Y money into the pot and the US has continued to put in solid performances has had a notable effect on markets. Meanwhile, the VIX has touched levels not seen since the start of the financial crisis (proper) in the middle of 2007. The latter is a very significant event, not least because one of the key features of the financial crisis was the under and mis-pricing of risk. So whilst stocks have been soaring (MSCI World up 3.5% over the past week), the traditional risk currencies have been in retreat and established correlations are fading. Take, for example, the Aussie, AUD/USD’s correlation (rolling 3mth) with the S&P has declined to the lowest level for 8 months. Having peaked above 0.90 it is now just above 0.71. A similar pattern is being seen with AUD/JPY although having fallen from above 0.90 to below 0.60, it has recently nudged up on the back of JPY weakness. But the rout goes far wider that just the Aussie. The Brazilian real has been pummelled of late, partly on the back of attempts by the authorities to limit capital inflows via the taxation of foreign loans and other measures. A similar pattern is also evident on the Korean won which is weakening as stocks have gained. Of course, whilst there are specific domestic reasons why these currencies are softer, it’s still telling that there are signs that the traditional high-beta carry favourites are looking tired at this point in time. For most (especially Brazil), this will be a welcome state of affairs, but for investors it changes the risk game substantially.

The vulnerability of gold. Gold bulls are starting to shiver and shake, with the price down another 2% yesterday to USD 1,646 an ounce. At the end of last month, it was close to USD 1,800; six months ago, it was touching USD 1,900. So, what is going wrong? Is this the end of the bull cycle, or simply a healthy correction after what has been a sensational run? Over that time, gold became the investment of choice for those who (justifiably) feared that the major central banks were deliberately debasing their currencies through policies such as quantitative easing. Additionally, gold was sought after as a store of value at a time when there was genuine concern over the stability of the global financial system, especially the European banking system. Notwithstanding the massive helicopter drop of liquidity that the ECB has provided to Europe’s hobbling banks, these concerns have not disappeared, although they have certainly lessened. At the same time as financial Armageddon was being temporarily averted in Europe, and with Greece avoiding a messy default, it has become apparent that the US economy is on a firmer footing and that German’s is withstanding the immense financial turmoil lapping at its doorstep. Gradually, both investors and traders have become more optimistic, aided by the incredibly generous liquidity being provided by all the major central banks. As such, what has started to occur is an abandoning of investments that are no-yielding (that is, cash, short-term government paper and gold) in favour of those that offer a high and sustainable prospective yield. US equities for instance are on a tear, helped by a highly elevated equity risk-premium, with the S&P already up 11% for the year to date. All is definitely not lost for gold. Holdings in gold ETFs reached a record high on Tuesday, so clearly investors still see some appeal. And it could be argued that central banks have merely postponed the day of reckoning through the provision of abundant liquidity.

The bond stocks switch. As investors and traders gradually cast off their collective fear about Europe imploding, Greece defaulting and China decelerating, a very significant asset allocation-shift is being unleashed. The avoidance of risk in the second half of last year and the excessive rush into the safety of cash and hard-currency sovereign bonds is progressively being unwound. Real money managers, conscious that interest rates are deeply unattractive at these exceedingly low yields, are progressively shifting into assets that offer much better yields. With the equity risk-premium in many markets at multi-year highs, it is little wonder that stocks are a major beneficiary of this shift in allocations. Since the beginning of February, the yield on the US Treasury note has risen by 40bp to a 5mth high of 2.18%. Meanwhile, the S&P 500 is up by 11% in 2012 to a four-year high, the DAX is 20% higher, and the Nikkei has risen by 19%. For their part, risk-takers are basking in the healthier glow in the US economy, the potential for easier monetary policy in China, the incredibly stimulatory monetary policy of the major central banks and the recent stabilisation of the eurozone sovereign debt and banking crisis. Right now, investors seem to regard stocks as a buy on weakness, which probably means bonds are a sell on strength.

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