Investors Hate the Three Horsemen of Uncertainty More than they Do Bad News

Stock Rally Runs Into A Storm of Uncertainty

The S&P 500 just ended its worst month since May 2012, but considering all the coming storm of uncertainty, it could’ve been worse. The DJIA, SP500 and Russell 2,000 have dropped below 50-day moving average support, as have the consumer discretionary, consumer staples, financials, healthcare, industrial, technology and utilities sectors within the S&P 500. The only indices/sectors still holding their 50-day MAs are NASDAQ, energy and basic materials.

Source: Yahoo.com

Source: Yahoo.com

Euroland stocks, where investors had begun to look for relative performance, are down 3.3% on the Eurostoxx 50 in recording its 2nd worst week in 11 months. EUR also had a bad week USD dropping back below 1.32. Interesting was the noticeable selloff in “less risky” core markets like Germany and France, while smaller markets like Belgium and Austria have managed to stay above their 50-day MAs. Spanish and Italian sovereign bond spreads jumped nearly 20bps, while Portuguese bonds were the hardest hit as Europe’s VIX spiked. 

Source: Yahoo.com

Source: 4-Traders.com

Emerging equity markets were already in a funk, as Brazil, India, Malaysia, Mexico and South Korean markets have already seen dead crosses between their 50 and 200-day MAs. Even once red-hot Japan (in USD-denominated EWJ MSCI Japan) has been unable to hold above its 50-day MA after attempting a rebound from a May hedge fund profit taking selloff. 

Source: Yahoo.com

What’s Bothering Stock Prices

What’s bothering stock prices? Basically, a significant increase in investor uncertainty, which they usually hate more than bad news, which can be better discounted than uncertainty. 

1. The first uncertainty was Fed chairman Ben Bernanke’s signaling of the Fed’s intention to taper back its “unlimited” QE program. The Fed appears heavily leaning toward implementing a tapering soon despite investor doubts about the sustainability of the US recovery, which could be further threatened by another fight over the US debt ceiling and military action in Syria. 

2. The second is another looming partisan fight over an extension of the US debt ceiling. There has been much confusion in the past several months relating to the US debt ceiling, and specifically the fact that total debt subject to the limit has been at just $25 million away from the full limit since late May. To avoid disruptions to the Treasury market, Congress will probably need to raise the deadline by mid-October. 

3. The third is “imminent” US military intervention in Syria. Secretary of State Kerry’s hard-hitting speech and reports that US action was “imminent” triggered rising crude oil and gold prices, while President Obama’s decision to back off and wait for US Congressional approval to act caught traders wrong-footed. The unrest, meanwhile, has proved a magnet for militant Islamists, including al-Qaeda affiliates and Iranian-backed Hezbollah. Refugee outflows, the threat of weapons proliferation, and widening sectarian rifts have stoked fears that the civil war may engulf the wider region. 

Reflecting this upsurge in uncertainty, the VIX has spiked, albeit well below what could be considered “panic” levels. Depending on how disruptive each of these on-the-immediate time horizon factors are, the current consolidation in global equity markets could linger, taking price levels back to intermediate-term support levels (e.g., 200-day moving averages) even if the long-term recovery trend is not broken, or even lower if the more bearish implications of each factor prevail. 

However, the looming Congressional fight over the budget ceiling and whether or not the US “punishes” Syria for using chemical weapons are inherently short-term market uncertainties, as is, to a lesser extent, the Fed’s tapering back of QE. Each factor of course has its cassandras warning of “dire consequences”. In the end, however, the outcomes, i.e., a shallow or more serious market correction, will depend on how sustainable the recovery in global balance sheets, economic activity and corporate profits is. 

Source: StockCharts.com

Crude Oil and Gold Corollary to Increased Market Volatility

The corollary to the uptick in S&P 500 volatility has been in the crude oil and gold markets. Crude prices (Brent) have rallied about 20% from April, while gold has rallied about 17% from late July lows, i.e., before the general perception that a US attack on Syria was perceived as “imminent”, on growing concerns about supply disruptions from Iraq, Libya and Nigeria from strikes and protests that have affected major oil terminals. Oil trading well above $100/bbl of course will act as a tax on the economies of nations most dependent on oil imports, including China and Japan.

Source: 4-Traders.com

Following a plunge in gold price that had some (including ourselves) declaring that the secular bull market in gold was “over”, gold has rallied some 20%, but is still well below the level seen before a selloff sent prices plunging 28% between January and April 2013. If direction of real interest rates is still basically upward, we still see little probability of new highs in gold, even though the recent market uncertainty has hedge funds and other speculators in late August at the highest levels in six months. 

Source: 4-Traders.com

More of the Same the Next Few Months 

Given that the Fed’s tapering, the debt ceiling fight and the Syrian question cannot be solved overnight, it looks like investors will be stuck with an increased level of uncertainty for the next few months, which implies continued consolidation in equity markets, somewhere between 50-day MAs and 200-day MAs. For the S&P 500, a pullback to its 200-day MA would bring the index back to the 1,550 level, or another 5%, following varying degrees of further consolidation in global equity markets. 

Assuming that the secular market trends established since March 2009 remain in place, the following table of 200-day MA levels and current prices indicates that the potential downside risk in an extended correction is greater for the NASDAQ, consumer discretionary, healthcare and Japanese equities, versus upside potential in US long bonds and gold…while crude oil could see a tumble, not a rally. Enhanced returns would be possible in the short-term by shorting the NASDAQ, consumer discretionary, healthcare and Japanese equities while going long long bonds and gold. Once the correction is over, however, these trades would need to be reversed. 

Source: Yahoo.com

Central Banks Increasingly Between a Rock and a Hard Spot on QE Wind-Down 

Investors remain under the impression that central bank quantitative easing is what has kept financial markets buoyant, papering over still-serious structural economic issues that are the legacy of the 2008 financial crisis. To a certain extent, this is true for financial markts. That quantitative easing is a “free lunch” way to increase wealth, however, is a magnificent illusion, at least as regards the two mandates of the U.S. Federal Reserve, a) employment and b) price stability. 

Even the IMF warns that a withdrawal from “endless” QE without a) a significant back-up in bond yields and b) a corresponding bond/equity market correction could be very tricky. As soon as central banks signal they are readying to halt QE (as the Fed has done), bond prices are “likely to fall sharply” as investors head for the door. The backup in rates could force central banks to push up rates even further to prove they have not lost control of inflation, i.e., more fuel on a market correction fire. The IMF warns, “The potential sharp rise in long-term interest rates could prove difficult to control and might undermine the recovery (including through effects on financial stability and investment). It could also induce large fluctuations in capital flows and exchange rates.” 

Further, even research by the San Francisco Fed indicates that “Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation; the key reason being that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.” 

Total Credit Market Debt Makes the (Economic) World Go Round, Not QE 

Thus withdrawal from QE will be tricky for financial markets, while even more QE means minimal impact on the real economy at best and a growing risk of other moral hazard bubbles that will have to be dealt with. How disruptive this attempted withdrawal will be hinges on the movement in total credit market debt, which is the real driver of modern economies, and consists of both private and public sector credit growth. Immediately after the 2008 financial crisis, credit availability from the financial sector’s shadow banking system shrank, taking the economy with it. This shrinkage (plus other private sector balance sheet adjustments) was eventually covered by the public sector, allowing for growth, albeit at weaker-than-normal-recovery levels. 

IF the pick-up in private sector credit creation is strong enough, the economy should continue to grow even as the Fed–whose QE-driven credit creation impact was doubtful at best–begins to scale back. 

Hat Tip: Zero Hedge

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

The Salad Days of QE Lifting All Financial Market Boats Are Over

The QE Tide is No Longer Lifting all Financial Market Boats

In early 2009, financial markets were crashing, world trade was virtually at a standstill and the global financial crisis had blown massive holes in financial institution balance sheets, as well as the portfolios of most investors. 

Central banks led by the Federal Reserve pulled out all the stops, rushing headlong into unprecedentedly unconventional monetary policy (quantitative easing, QE) to establish a backstop to keep the global financial system from imploding, and governments began writing fiscal checks like crazy to stop-gap the sudden lack of private sector demand.

The desperate monetary measures worked. From the depths of the global sell-off in March 2009, financial markets snapped back like an over-stretched rubber band. But as central banks attempted to transition their emergency monetary policy into a viable replacement for increasing fiscal retrenchment, they found themselves throwing more and more money at the problem (lack of private sector demand and deflationary pressures) but seeing less and less results.

Over four years since the big crash, financial markets are now in flux, with some establishing new post-crisis rebound highs (like the S&P 500), and others crashing from post-crisis rebound highs to new lows (like copper). Emerging markets, once seen as the new driver of post-crisis global growth, are now sputtering. The Eurozone is barely stable and could be the best candidate for a Japan-style decade of malaise. Gold, and major industrial commodities may have already seen the peak of this supercycle. Even equities, the now-preferred asset class, could see more return on capital and return of capital-endangering cross-currents. 

Crude Oil Rallies

The Egyptian army has suspended the constitution and removed President Morsi. Egyptis back to where it was it was two years ago. The Arab world political powderkeg has again exploded; high proportions of young people and high proportions of youth unemployment – are making for explosive levels of discontent from Moroccoin the west to Syria and Yemen in the east. Turkeystands at the cross-roads.

The resurgence of geopolitical risk has spilled over into the crude oil market, causing crude oil to break to the upside above $100/bbl. But crude oil prices were on the rise before the latest set of protests in Egypt broke, as cyclical factors have begun to turn in its favor.  Price declines have pushed producers to involuntarily cut production, while spare capacity remains tight.

As prices were already coiling to move higher, the resurgence of political unrest in the Middle East could propel crude prices to over US$130/bbl, representing fairly quick 30% upside. 

Sources: 4-Traders.com, StockCharts.com

But This Rally Is Not Helping Industrial Commodities: Bottom Falling Out of Copper Prices

Bad news from China, heretofore the primary source of new demand, has triggered a crash in copper prices to new post crisis lows. Miners say China is not Copper’s only problem. A plethora of events have hit copper prices the past month, from a sluggish China, comments by Fed regarding a slowdown of bond-buying and a weaker manufacturing environment. Some mining analysts are suggesting Copper’s supercycle could well be entering the secular decline phase. Deutsche Bank and Macquarie expect copper supply between 2013 and 2015 to exceed demand by an average of roughly 500,000 metric tons a year—higher than the surplus in 2009, when the average price fell 26%. The medium-term headwind is better economic prospects in the U.S. and Fed tapering that should support a stronger USD, capping copper’s marginal costs in dollar terms, and therefore prices.

Copper, already down a massive 54% from 2011 highs, could, as indicated by point & figure charting, collapse another 50%, even though a short-term bounce from already severely oversold levels is inevitable–i.e., if you want to try and catch the falling knife, be our guest. 

Sources: 4-Traders.com, StockCharts.com

Gold Collapse a Different Dynamic than Copper, But Nevertheless a Collapse

Gold has also collapsed, while the dynamic for gold is quite different than for copper. Historically, negative real rates have been a key driver of secular bull markets in gold. Negative real rates nullify the standard gold criticism that it doesn`t pay a yield. 

Gold is recently rallying on, a) selling pressure on USD, b) haven demand from political turmoil in the Middle East. However, this bounce could be transitory. While already collapsing to USD1,200/ounce from USD1,900/ounce, point & figure charts indicate 20% more potential downside. 

The Great Rotation from Bonds to Stocks is a Work in Progress

Bonds perform best in times of deflation/disinflation, where weak economic conditions mandate that the central banks maintain an easy money stance. But bonds are extremely sensitive to inflation expectations and Fed policy. When investors still believed Bernanke’s promises of “unlimited” QE and there was little confidence in a sustainable US economic recovery, 10yr treasury yields were hitting new lows, of 1.4345% in the autumn of 2012. As confidence in the US economy returned as Congressional hot wind about debt ceilings passed, just a hint from Chairman Bernanke about a possible gradual unwinding of QE was enough to send 10yr yields shooting upward 123bps from the 2012 lows to 2.6647%. 

Thus the ostensibly good economic news (housing on the mend, consumers spending, etc.) and hints of a shift in Fed policy were enough for a 25%-plus selloff in 30yr bond prices from mid-2012 highs, while the point & figure charts indicate another 10%-plus downside is possible. Here again, any opportunities should basically be trading turns, while the prior secular trend is clearly turning. 

Sources: Yahoo.com, StockCharts.com

There is Also Increasingly Selectivity in the Preferred Asset; i.e., Equities

Looking at the alarming sell-offs in commodities, gold and bonds, the obvious implication is that equities have become the preferred overweight asset. Here again, however, there is increasing divergence between the loser and winner markets as well as loser and winner sectors, which leads some to suggest that any major regime change (i.e., from a deflationary environment to inflationary environment), while favoring equities “for the long term”, will inevitably involve an interim correction for all financial assets, including equities–even if there is no re-collapse into the dark days of the 2008 global financial crisis.

The table below charts the year-to-date performance of major assets. While negative performance for holders, the over 40% spurt in 10yr treasury yields, as is keeping with the long-term history, has been very positive for the Nikkei 225. The surge in these two instruments is followed by USD gains against JPY and then the S&P 500, the gains for which have come despite the spurt in treasury yields. On the other end of the spectrum (the losers) is gold, emerging market equities, copper and the Shanghai equity market, in that order. While there will be inevitable backing and filling, we believe the general direction as shown YTD is the “true” market trend–meaning investors will continue to favor; Japanese equities, USD, and S&P 500, while shying away from gold, bonds, emerging market equities and China equities in particular.  

Source: BigCharts.com

Fed Tapering, If the Fed is Right about US Growth, is Good for Japan

In the four years from the depths of the global financial crisis, Japan’s fiscal and monetary mandarins have been a day late and a dollar short in attempting to address the problem. Now, this is, as is widely perceived, changing with the advent of Abenomics. But the easy money, i.e., where just the whiff of major change is enough to drive asset prices, has already been made in Japan as well.

JPY/USD, the key metric since Abenomics burst on the scene late in 2012, has already depreciated some 30% since early 2012, triggering a near-doubling of the Nikkei 225 before short-term, but heavy, profit taking set in. The top in the Nikkei 225 was established as Haruko Kuroda was named as the next BoJ governor, and announced his “everything including the kitchen sink” shock and awe quantitative easing program. Problem is, Kurodo is finding it difficult to come up with an equally impressive follow-on to his first act. A tapering Fed versus a “peddle to the metal” BoJ means a more substantial US-Japan bond yield spread that will a) continue to exert downward pressure on JPY versus USD and b) support further gains in the Nikkei 225. 

Deep-Seated Doubts About the BoJ’s 2% Inflation Target 

Rather than keeping a tight lid on JGB yields, the BoJ’s bond-buying program triggered a substantial amount of unwanted volatility into the JGB market, and yields temporarily doubled to 1% before settling down, understandibly spooking the very domestic bond investors that have allowed Japan to enjoy record low rates despite a soaring government deficit. At the same time, Japan’s largest pension funds see history as being against the BoJ as it undertakes unprecedented asset purchases in pursuit of a pledge to overcome 15 years of deflation. They are therefore in no hurry to shift assets out of bonds into equities. 

Abe and His LDP Colleagues are no Ideologs 

During the prolonged recession, Japan lost some US$500 billion in gross national income, equivalent to the disappearance of an economy the size of Norway or Poland. Prime Minister Abe is a pragmatist. He recognizes that there is no magic bullet to instantly fix Japan’s long term, structural challenges. He is certain, however, that targeting specific ‘catalysts’ with decisive and ambitious policies can create a broader knock-on effect on the economy than a patchwork of smaller, modest ones. These “decisive and ambitious” policies to re-invigorate Japan’s economic engine include,

• Reverse a deep-seated “deflationary mindset”
• Increase participation by women in the workforce
• Open up’ Japan and its markets to more foreign trade (economic partnerships, etc.)
• Attract more foreign investment (e.g.‘National Strategic Special Zones’)
• Make re-development of urban areas easier (e.g., relax construction regulations)
• Implement more structural regulatory reforms (e.g., electric power)

Such goals have been stated and plans implemented many times before with little lasting impact, primarily because of inbred resistance from factions within the ruling part itself, and deeply embedded resistance from domestic vested interests, such as the electric power industry, and last but not least, the simple inability to maintain a stable government long enough to see implementation through. 

Tokyo Black Swan: BoJ Loses Control of the Bond Market

As Ben Hunt via the John Mauldin newsletter, from a behavioral finance perspective, the narrative that “gold is money” has been replaced by the narrative of central bank omnipotence, where central banks have the ability to control market, if not economic, outcomes. In other words, the old Wall Street admonition, “Don’t fight the Fed” is alive and well, and stronger than ever. 

This common acknowledgement that central banks have the (omnipotent) ability to control outcomes is diametrically opposed to the narrative that economic events will spin out of the control of central bankers, precluding some big monetary policy mistake that cannot be fixed without re-conceptualizing the global economic regime and triggering hyperinflation, collapse of the Euro, etc., etc. This means the greater the strength of the omnipotent central banker narrative, the weaker the commitment to gold as an alternative currency. 

However, while the efficacy of the omnipotent central bank narrative is strong with regards to the Federal Reserve, it is much less so with the ECB, and even less so with the BoJ, as evidenced by the dramatic increase in JGB volatility. Consequently, while the majority of investors would strongly contest the notion of the Fed losing control, there is a real probability , albeit small, assigned to the notion that the BoJ could lose control.

The balance of private sector bank current accounts held at the central bank is projected to decline JPY18.3 trillion yen in July, accounting for bank notes and treasury funds. On the other hand, net issuance of government securities are seen topping JPY16 trillion despite the BoJ’s JPY7.5 trillion/month purchases, or the equivalent of 70% of government bond issuance. This is sapping funds from the market, despite the BoJ’s pledge to double the monetary base by the end of next year. Even factoring the bank’s expected buying, the current-account balance would still decline by roughly JPY10 trillion.

Can the BoJ pull it off? concerns aside, it is advantage Abenomics, as there is evidence of improvement in Japan’s economy and of positive price movement as opposed to more deflation. Recent price data for May show prices have “improved” to flat instead of ongoing declines. Business and consumer sentiment have steadily improved since Kuroda’s April 4 announcement. Firms expected a decrease in capital spending for fiscal 2013 in the BOJ’s March tankan, but firms in the June survey projected an increase. while the shipment index of capital goods, a leading indicator, showed an increase in May.

With JPY/USD weakening below the psychologically important JPY100/USD and signs of economic recovery, the Nikkei 225 is back above its 50-day MA and never really tested its 200-day MA despite a very nasty interim correction. The point & figure chart is indicating limited immediate upside potential of roughly 5%, implying we may not see new rebound highs until after the July upper house elections and a fleshing-out of Abe’s “third arrow” of initiatives to revive Japan’s potential growth. Any meaningful consolidation in US equities will of course act as a “risk-off” drag on Japanese equities as well, but rising US 10yr bond yields, as we have shown, is actually a positive for the Nikkei 225. 

Source: Yahoo.com, StockCharts.com

JPY/USD has tested JPY94/USD and successfully held, while JPY100/USD is becoming support instead of resistance. The point & figure chart indicates there is still significant weakening potential of 37% in JPY/USD, meaning the “short JPY/long Nikkei” trade is alive and well after a brief shake-out. 

Source: 4-Traders.com, StockCharts.com

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Fed Policy is Not one of the Global Canaries in the Coal Mine

U.S.: Making Mountains Out of Molehills?

The past couple of weeks have seen a shift to risk off and an unwinding of carry trades triggered by the U.S. Federal Reserve’s infamous “taper” comments. The following chart comparing the S&P 500 and Bloomberg’s U.S. economic surprise index (hat tip: Zero Hedge) shows the growing disconnect from March of this year onward between economic expectations and stock prices—i.e., U.S. stock prices were reaching new highs while the macro index was hitting new lows. Thus a “mark to economic reality” for US stock prices was overdue before Chairman Ben’s comments. The only investors that should have been “shocked” by the move in US stocks recently are those who had heretofore been waiting for a meaningful correction but already caved in and bought the market…just before Chairman Ben set traders scurrying to unwind positions. 

However, the equity market’s sanguine reaction to worse-than-expected Q1 GDP data does indicate a) underlying confidence in the US economy’s ability to continue recovering and b) that the factors supporting stock prices are not all central bank cool aid. Despite the inevitable backing and filling, the trend in the S&P 500 is still up. With the point & figure chart of the 30-year bond indicating some 8% more downside for 30yr treasuries, the point & figure chart for the S&P 500 is indicating something more like total downside risk of some 11% to 1,500, i.e., not a new secular bear market. Assuming the S&P 500 corrects to its current post-crisis recovery trend line, it is obvious there is still some more short-term downside risk in stock prices….but not, as yet, evidence of a serious cracking of US stock prices.

Hat Tip: Zero Hedge

Bonds Were Beginning to Selloff Before Chairman Ben’s Infamous “Tapering” Comments

30yr US treasury prices already peaked mid-year at the height of risk aversion in 2012. Since then, the 30yr TB has sold off nearly 13%. Since the early 2012 low of 135.38 is not apparently holding, the Point & Figure charts are indicating another 12% or so of downside risk. Weighing on bond prices is a) better confidence in the sustainability of the US economy (housing, employment, etc. improvement), and b) the possibility that the Fed begins backing off earlier than latter, and c) waning concerns about the strength of the global economy. 

From a long-term perspective, the writing is on the wall for bonds, US treasury prices are clearly breaking down. The issue then becomes if the unwinding of the great bond rally becomes a gradual selloff or a full-scale rout. Since long bond prices were already consolidating before any hint of Fed tapering, we would guess that the the “good” upward pressure on bond yields, i.e., improving economic expectations, as well as reduced global tail risk are not insignificant factors in current bond yields.

On the other hand, since the repair process in the Eurozone and Japan significantly lags that of the U.S. and growth in the emerging markets is less than stellar, inflationary expectations remain, in Fed-speak, “well-anchored”. 

Hat Tip: StockCharts.com

Historically, rising rates have not always meant falling stock prices. In the great run-up of bond yields culminating in the oil crisis peak, the worst damage to stock prices (then, a secular bear market) was as bond yields rose from 4% to 8%. Thereafter, however, stock prices entered a 28-year bull market even as yields were spiking to 16%–implying that the mix of economic factors is just as important or perhaps even more important than interest rates alone. 

Hat Tip: The Big Picture

Watch the Global Canaries in the Coal Mine 

From a tail risk perspective, investors are less afraid of the impact on US equities from an easing of the Fed’s heavy $85 billion/month boot on the US bond market than they are of, a) the potential downside in bond prices, b) renewed crisis in the Eurozone and c) a sputtering Chinese economy. Thus compared to other financial markets, the correction in US stocks so far is a tempest in a teapot because US stocks remain the best game in town, or alternatively, the least dirty shirt in the closet to those of a more bearish persuasion.  

Globally, the real canaries in the equity coal mine are the Eurostoxx Banks index (as an indicator of renewed Eurozone sovereign debt crisis risk) and the Shanghai Composite (as an indicator of the state of the Chinese economy). The Eurostoxx Bank index is in the process of confirming 2012 lows, while the Shanghai Composite has collapsed to a new low. 

Both of these indices remain in long-term bear markets after a brief but sharp bounce in 2009. The Eurostoxx Bank index, which has surged some 75% as sovereign bond yields in the troubled southern Eurozone nations plunged on assurances by Mario Draghi and the ECB that they would do whatever it takes to “save” the Euro, has quickly given back over 20% of the recent high above 127. However, the index remains well above the 2012 low, although it is in the process of testing downside resistance. On the other hand, the rebound in the Shanghai Composite from the 2012 low has been much more anemic as the Chinese central bank struggles to contain a property/housing bubble, and the interbank liquidity squeeze has sent the Shanghai Composite plummeting below its 2012 low. The renewed selloffs in both indices bears close watching, because a dramatic slowdown in the China economy and renewed crisis in the Eurozone are something that “got your back” Chairman Ben cannot help you with.

Hat Tip: 4-Traders.com

The Implications for Other Emerging Markets and Commodities are Not Good 

The implications of renewed lows in both of these indices are already being discounted in the commodity and emerging markets, both of which are more sensitive to risk asset flows. This can be seen in the breakdown of support in both Copper and the EEM MSCI Emerging Market ETF. While the recovery in the US housing market should be good news for copper, everyone knows that demand from China has been the incremental driver of demand for copper and other major commodities. Emerging markets in Asia are of course closely tied with slowing import demand from China, whose real GDP growth is looking much less than the headline 7% or so quoted by most public and private sector economists. 

It is too early to tell if trying to catch these falling knives will yield short-term results, while the road back to prior highs is becoming more difficult with each day. Hear again, US equities remain the default choice.

Hat Tip: 4-Traders.com, BigCharts.com

Investors Can No Longer Hide Out in Gold 

Gold (especially paper gold) as an alternative currency and safe haven is rapidly losing its luster, as the relative attractiveness of the yellow metal dramatically shifts as real interest rates turn positive and the serious “infernos” around the world (e.g., Eurozone crisis, etc.) begin looking more like brush fires. 

Gold bugs and precious metals analysts will give you all sorts of technical reasons why gold prices are about to bottom, but (paper) gold prices have plunged through 1,550 and 1,350 support like hot butter, and while dramatically oversold short-term (and thus susceptible to short-term bounces), the dramatic rally since 2009 is clearly over, with previous calls for $2,000 or $3,000/ounce now looking like a pipe dream. 

We see driver of lower paper gold prices as being fairly straightforward, i.e., positive real interest rates, and believe those who are in paper gold as an “investment” are in for more pain. On the other hand, the strong underlying demand for physical gold as an emergency fund is stronger than ever. 

Hat Tip: 4-Traders.com

The Eventual Success of Abenomics Hinges on Structural Reforms 

The LDP (Liberal Democratic Party) winning back power and the bursting of Abenomics on the scene generated a quick nearly 90% gain in the Nikkei 225 from mid-October 2012, as JPY/USD dropped nearly 25% in equally quick fashion. A sharp back-up in JGB yields on high volatility from a new low of around 30bps to over 1% however shook some short JPY, long Nikkei 225 macro traders out and even encouraged some opportunistic futures short selling, and the stock index remains extremely sensitive to JPY/USD, which also saw a sharp short-term snap-back—against the background of continued heavy net selling of Japanese equities by domestic institutions. 

The accelerated downtrend in the Nikkei 225 as Japan was hit by the Great East Japan earthquake/tsunami/nuclear power plant disaster only exacerbated the damage done to Japan’s economy and financial markets by the 2008 financial crisis, delaying recovery well beyond what was happening in the U.S. An ineffectual Democratic Party of Japan (DPJ)-led government only made matters worse. Thus in the very least, the Abe Administration has managed in a few months to repair the damage to stock prices from the Great East Japan disaster by drawing record amounts of foreign buying and giving long-suffering domestic businesses and individuals reason for hope. 

Hat Tip: 4-Traders.com

Domestic Institutions Remain Structural Net Sellers of Japanese Equity 

The sharp reversals in both the Nikkei 225 and JPY/USD indicates that the big money has already been made in the Abenomics trade. The biggest quarterly rally in Japanese stocks in 25 years did not impress domestic institutions, who if anything have been accelerating their unloading of Japanese equities. As of end March 2013, Japan’s insurers, lenders and trust banks pared their holdings of Japanese shares to 28% of total market value, as the share held by foreign investors surged to 28%. Domestic institutions have been net sellers of Japanese equities every week since mid-November 2012 through June 14, 2013. 

Basically, domestic investors aren’t buying Abenomics. Too many past governments have come and gone with grandiose promises that never made much of a dent in Japan’s structural problems. Thus domestic institutions remain very much in a “show me” mode, and structurally constrained from a more constructive “risk-on” mode. Basically, these institutions have little incentive to pursue higher returns (risk) while they have many reasons to avoid risk. Thus their share of total market trading fell to a mere 4.7% last month. On the other hand, individual investors are now accounting for more than 40% of trading volume, making the Japanese stock market one of the most volatile in the developed world. In terms of stock price formation, it is anywhere and everywhere foreign investor driven. 

What this means is that Japanese stock prices are likely to remain volatile, as foreign hedge funds and domestic traders whip around market prices at significant inflection points. Abenomics still has forward momentum, but the “shock and awe” factor has melted away to reveal deep underlying skepticism. 

While Japan’s giant GPIF (government pension investment fund) did hint at higher future allocations to risk assets including equities, new asset allocations announced on June 7 are in line with those as of end December 2012. Basically, it is very unlikely that these institutions will in the foreseeable future ever play a meaningful role as a net buyer of stock. Market volatility has given domestic instituions another excuse to stay away from equities. 

With foreign investors more risk adverse and trimming back on more volatile trades, it is unlikely that a new high in the Nikkei 225 or new lows in JPY/USD will be hit anytime soon. More likely is a fairly well-defined trading range as these markets consolidate the sharp moves of the past six months.

Making the Most of Borrowed Time? 

Despite the recent jitters about Chairman Ben’s tapering comments, the fact remains that the US Federal reserve is still the most trusted central bank among investors in the world, regardless of disparaging comments to the contrary. While the Fed’s tapering comments may have appeared to some to come out of the blue, recent comments by the Bank of International Settlements are probably a good reflection of the debate that is going on within the walls of the world’s central banks. 

Central banks can be commended for having bought the private and public sectors the time need for adjustment from the 2008 financial crisis and worst recession since the 1930s depression years. Since the beginning of the financial crisis almost six years ago, central banks and fiscal authorities have supported the global economy with unprecedented measures. Policy rates have been kept near zero in the largest advanced economies, and central bank balance sheets have ballooned from $10 trillion to more than $20 trillion, and the stimulus has surged 500% since 2000 to $16 trillion. Meanwhile, fiscal authorities almost everywhere have been piling up debt at an alarming rate, which has risen by $23 trillion since 2007. Half a decade ago, most, if not all, of these measures were unthinkable. 

Their preeminence of central bank policy shows how much responsibility and burden central banks have taken on. Problem is, nobody knows exactly how central banks will exit from this unprecedented monetary stimulus, or what they will exit into. What the BIS is sure of is that central bank stop-gap measures are reaching their limits, and are now warning that “more bond buying would (actually) retard the global economy’s return to health by delaying adjustments to governments’ and households’ balance sheets. In other words, the central bankers’ bank is now making the same warnings about excessive monetary policy as QE skeptics have been making for some time. 

According to “Making the Most of Borrowed Time”, by Jaime Caruana, General Manager of the BIS; “Six years have passed since the eruption of the global financial crisis, yet robust, self-sustaining, well balanced growth still eludes the global economy. If there were an easy path to that goal, we would have found it by now.” The conclusion is “central banks need to begin heading for the exits and stop trying to spur global recovery”. 

Why? The bottom line is that monetary stimulus alone simply cannot provide the answer. The roots of the problem are not monetary. Central banks cannot repair the balance sheets of households and financial institutions, cannot ensure the sustainability of fiscal finances, and most of all cannot enact the structural economic and financial reforms; all needed to return economies to real growth paths. To be fair, without these forceful and determined policy responses, the global financial system could easily have collapsed, bringing the world economy down with it. Thus monetary policy has done its part, and real recovery now requires a different policy mix, one with more emphasis on strengthening economic flexibility and dynamism and stabilizing public finances. 

In Addition to a Dysfunctional Money Multiplier and Depressed Velocity of Money, the Keynesian Multiplier is also Dysfunctional 

The chart from GaveKal below shows clearly just how clueless the “don’t worry about the debt, just add more Keynesian stimulus” crowd are. The chart shows that the marginal efficiency of public debt, at least in the US (public spending in emerging markets from a low base usually improves productivity) has been declining structurally since 1981. Further, it seems that this marginal efficiency has now reached a negative level, i.e., more debt is just not going to cut it.

Hat Tip: John Mauldin

Significant Tail Risk? 

The implications of both the BIS observations and the Gavekal points about the Keynesian multiplier are that BOTH fiscal and monetary policy are near their limits in terms of having an actual positive impact on the real economy. Simply stated, the real role being played by central banks is becoming more of a confidence game than statistically demonstrable positive effect. In reality, the pace of repair and reconstruction is now up to the private sector, not government fiscal or central bank monetary policy. Real economies remain burdened with heavy debt loads and impaired balance sheets. While unprecedentedly unconventional monetary policy that has tried to alleviate/prevent the pain of adjustment, the recovery in the real economy continues to significant lag that in the financial markets. 

This “bubble” central bank stimulus bubble component in asset prices implies significant tail risk if investors ever lose faith in the ability of central banks to at least provide a backstop. Should this faith dissipate, it could get ugly very quickly, such as a dramatic surge in financial repressed bond yields causing crippling, systemic losses, amounting to trillions of dollars for bond and stock investors around the globe, to the tune of 8% of GDP (or more than USD1 trillion if yields were to rise by 3 percentage points across the maturity spectrum). In Japan the potential losses would be a mind-blowing 35% of GDP. Losses in France, Italy, and the United Kingdom would range from about 15% of GDP. In the understatement of the century, the BIS concludes, “interest rate increases pose risks to the stability of the financial system if not executed with great care”. 

Federal Reserve Chairman Ben Bernanke has likened monetary policy to landing a jet on an aircraft carrier; i.e., at lot could go wrong between “unlimited QE” and the eventual exit. Bouts of positive correlation of equities, bonds and commodities, suggest that extraordinary monetary stimulus has created bubbles in a broad range of financial assets. Any untoward removal of said stimulus could therefore create a tail event in which prices of all assets dramatically go down. 

Let’s hope that Chairman Ben and other central bankers are humble enough to realize the real short-comings of monetary policy, while at the same time are politically savvy enough to continue playing the confidence game–i.e., being brutally honest and telling investors/businesses that there is nothing further they can do is not the message that should be sent. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Deflationists are Forecasting Something that Happened Five Years Ago

Just How Much “Fundamental” Support is there for Stock Prices? 

Academics who have analyzed the historical relationship between GDP growth and stock price performance across developed and developing country markets find a very tenuous correlation between GDP and aggregate stock prices that is typically quite low and even negative. O’Shaughnessy Asset Management is among others who say the correlation between aggregate GDP and stock prices is non-existent… EXCEPT that you would historically earned a 21% one-year return if you invested when GDP is less than zero percent! By the same token, investing when consumer confidence is below normal produces average five year annualized returns of 11.5%, but the correlation is zero looking one year out. 

However, a significant relationship can be found between equity returns and expected GDP growth. By the same token, market returns are unrelated to past earnings, but are influenced by changes in expected returns, expected cash flows and expected discount rates. Callagn, Murphy, Parkash and Qian (Journal of Investing, 2009) show stock prices to be a function of long-term earnings forecasts, while stock prices reflect not only the average of the IBES long-term earnings predictions but also some superior forecasting power beyond that aggregated average prediction. 

The bottom line therefore is that stock prices are driven by changes in investor expectations and perceptions of future “fundamentals” (e.g., GDP growth, earnings, discount rates). These changes are hard if not impossible to objectively measure. 

Market Conditions Now are not “Normal” 

Despite the dire warnings of debt deflation cassandras, realistic investors must accept that the Keynesians and monetarists, who generally foresee a 1930s-style slump unless the economy is stimulated out of it, are in charge. Rather than repeatedly pounding the table about the errors of Keynesian/monetarist ways, investors must accept that the world’s central banks will continue pumping dump truck loads of fiat money to ensure their economies do not fall into a deflationary spiral. Basically, the deflationists are forecasting an event that happened five years ago, when the worst fears of a 1930s-style slump was disproved by massive monetary intervention. 

This does not mean the post 2008 slump is over: far from it. But it is more realistic to assume the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented.　On the other hand, the massive central bank debt monetization IS eroding confidence in government and ultimately its paper fiat money, and this, we believe, is behind the world-wide rush into physical gold despite the crash in paper gold prices.

Source: 4-Traders.com

No Sell in May and Go Away this Year? 

The news flow about economic growth is not as good as investors were expecting a couple of months ago. Risk markets reacted negatively to the generally weak April global PMIs (purchasing manager indices), particularly those for Germany and China. Instead of triggering a selloff, however, bad PMIs, particularly Eurozone composite PMI where a sub-50 reading indicated a recessionary a drop in activity for the nineteenth time in the past 20 months, only led investors to expect further monetary easing in the Eurozone. 

                            

US business cycle and survey-based surprise indicators have plunged. Further, the lower highs being made in these indicators of the business cycle suggest the spillover effects of QE are also disappointing.

Source: Bloomberg, Hat-Tip: Zero Hedge

Yet Stock Prices Continue to Grid Higher 

Yet investor confidence that the Fed, ECB and the BoJ “have their back” remains strong, despite ample evidence that central banks are still largely pushing on a string in getting massive monetary base money to circulate into the “real” economy, as evidenced by the money multiplier and velocity of money. As we have repeatedly argued, quantitative easing can help keep financial systems/banks afloat in the immediate aftermath of a financial crisis by backstopping bank balance sheets and acting as the lender of last resort. But in a liquidity trap, not only can the Fed not control the money supply (M2) and the money multiplier, it can’t control the velocity of money either. And that means the Fed alone can’t create rising aggregate demand as long as the transfer mechanism (money multiplier) between the monetary base and M2 remains broken/dysfunctional. In this regard, the notion that the Federal Reserve is “printing money” is false, at least as regards “real” as opposed to “monetary” money supply. While the Fed expanded the monetary base (currency (notes & coins) in circulation + commercial bank deposits at the central bank) from $840 billion to $2.93 trillion (+249%), year- over- year expansion of M2 is recently only 6.8%…Ergo, the empirical evidence is clear that high- powered money is not causing a corresponding increase in “real economy” money.

Source: FRED

While a 1930s-Style Debt Deflation Has Been Averted, Has a Japan-Like Malaise Also Been Averted? 

Given massive central bank intervention, the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented. But the jury is still out whether a Japan-like decades-long malaise has also been prevented.

Source: Bank of Japan

Inflation Expectations are Still Falling 

The great rotation from bonds into stocks that was all the rage just a couple of months ago is not. The St. Louis Fed’s 10-year inflation forecast based on the yield spread in 10yr treasuries (nominal) less inflation-indexed notes shows a sharp drop-off, leading to lower, not higher bond yields. The much feared monetary tsunami-inflation link has yet to be seen.

Hat Tip: Capital Spectator

But Government Sector Intervention IS Supporting Positive Total Credit Growth 

Yet while central banks continue pushing on the perverbial string, the U.S. economy IS growing, albeit anemically. The following chart tracks the YoY change in total credit creation in the US. During and after the financial crisis, credit provided by the financial sector plunged, and is still declining YoY. If this were the only source of credit, the US economy would still be in recession. Fortunately, the credit “hole” in the financial sector was plugged by the government sector, allowing positive, but tepid, growth to continue.

Source: FRED

The Fed has been able to influence risk appetite and inflation expectations with QE, and by goosing risk asset prices, has supported the economy through its own version of “trickle down”. On the other hand, total credit IS growing. Thus instead of looking at the monetary base and the money supply, investors should follow the trend in total credit creation as the gauge of real support for the economy.

Source: FRED

Is the S&P 500 and US Stocks on the Verge of a 1970’s Breakout Moment? 

As previously mentioned, stock prices continue to grind higher, to pre 2008 crisis levels. The central bank “puts” undoubtedly have set a floor under downside risk, but is this the only factor driving stock prices? We suspect not. Since the 2009 low, the bears have been consistently wrong. In other words, the stock market is acting like it`s in a secular bull, not bear market. As Ralph Acampora states, “the low, in March of 2009, was a generational low. Part one of a secular bull market, this period that we’re in, is led by investor disbelief and fear.” 

Firstly, as mentioned, there is the renewed growth in total credit. While the degree of recovery is debatable, the surge in housing stocks, the expectation is that housing is on the mend and again positively contributing to growth instead of detracting from it. In addition, Exxon says the energy renaissance in the U.S. will continue and predicts that North America will become a net exporter of oil and gas by the middle of the next decade. The U.S. Energy Information Administration (EIA) reckons that imported liquid fuels as a share of total U.S. liquid fuel use reached 60% in 2005, dipped below 50% in 2010 and fell further to 45% in 2011, and should further decline to 34% in 2019, while the International Energy Agency (IEA) projects the U.S. could leapfrog Saudi Arabia and Russia to become the world’s biggest oil producer by 2020, and a net oil exporter by 2030. This represents a major watershed event for the U.S. economy. 

The U.S. stock market is already looking much stronger than past modern-era bear markets adjusted for inflation.

Hat Tip: DShort

When Will the Great Japan Trade Run Out of Gas? 

In case you haven’t been paying attention, the Japanese stock market is on an epic run. The Nikkei 225 is up 60% since last November when government officials began hinting at big policy changes that have since come to be known as “Abenomics”. As previously stated, academic research indicates that market returns are unrelated to past earnings/economic performance, which is what most of the economic data and earnings announcements represent, i.e., past performance. The real drivers of stock prices are changes in expected returns, expected cash flows and expected discount rates. 

From the dramatic reaction in JPY exchange rates and Japan equity benchmark indices, you’d think that something had not just changed, but that we’re looking at a new economy entirely. Within the realm of investor expectations, that is exactly what has happened. Bloomberg’s William Pesek and other skeptics are asking “where is the beef?” in Abenomics and points to a disconnect between perception and reality. 

Unfortunately, Mr. Pesek and others don’t get the importance of expectations vis-à-vis reality, aka George Soro’s Theory of Reflexivity. In the modern “financial” economy, changing (this time entrenched) expectations is half the battle. 

In the long 20-year Mother of all Bear markets malaise, Japanese stocks have seen many virulent but brief surges in stock prices, as is shown in the chart below, in of the prior cases, however, the government and BoJ were never able to “permanently” change investor and business expectations, and the economy as well as financial markets repeatedly slipped back into lethargy and lower prices. Even the Koizumi reforms, which produced the best rebound (over 100% in total) to date, eventually fizzled.

Hat Tip: Pragmatic Capitalism

In its latest Japan survey, the OECD forecasts the Japanese economy will grow by about 1.5% annually in 2013 and 2014, and hails Prime Minister Shinzo Abe’s three-pronged strategy — bold monetary policy, flexible fiscal policy and a growth strategy – as a plan to end 15 years of deflation and reviving economic growth. 

Yes, Japan’s gross public debt reached 220% of GDP in 2012, the highest level ever recorded in the OECD area, while the budget deficit is hovering around 10% of GDP, and “it remains critically important for Japan to address extremely high and still rising levels of government debt and other challenges posed by its ageing population,” as pointed out by the OECD Secretary-General Angel Gurría. The OECD also has also correctly emphasized that Japan needs to use regulatory reform to boost sustainable growth; particularly in the agriculture sector. The OECD believes Japan can create a more competitive agriculture sector by promoting consolidation of farmland to boost productivity, phasing out supply control measures, and shifting to less distorting forms of government support. Other potentially effective reforms include a) promotion of “green” growth and restructuring of the energy sector and b) increased women’s as well as older worker participation in the labor force to maximize its human resources. Reforming the tax and social security system, encouraging better work-life balance, and increasing the availability of affordable childcare would go a long way in this direction. 

Break Above 18,000 Would Represent a Real Change of Trend 

While the Nikkei 225 has already seen a parabolic move off historical lows, it would have to break up decisively through the Koizumi-era high of over 18,000 to represent a real change of direction from the market secular downtrend since the 1989 historical high.

Source: Big Charts, JapanInvestor

Japan “passers” such as Pragmatic Capitalism’s Cullen Roche initially dismissed the BoJ’s no-holds-barred QE as a ponzi scheme, but are now openly wondering, “what if monetary policy is much more powerful outside of a BSR (balance sheet recession) than we presume? By the same token, if the Abenomics bold experiment (which is basically the Fed’s playbook on steroids) actually works, what does that imply for the eventual outcome of the Fed’s monetary blasphemy? 

JPY is Far From All-Out Collapse Territory 

Axel Merk of Merk Investments as well as others (most notably Kyle Bass) insist that the BoJ’s monetary blasphemy and the governments “depression era” fiscal policy will render JPY “worthless”. We would counter that JPY is merely in the process of returning to a pre-financial crisis trading range. 

As seen in the chart below, the snap-back from a historical low versus USD in 1995 was just a rapid, but did not represent a secular trend change. As JPY/USD has yet to even reach prior highs in the late 1990s and early 2000, or even exceed the psychologically important JPY100/USD, it is way to early to declare JPY has permanently collapsed. 

Further, as Stephen Jen of SLJ Macro Partners has pointed out, it is Japanese investors, not global hedge funds, that will determine JPY eventual fate.

Source: 4-Traders.com

All that Japan really needed to revive its export competitiveness was a 30% currency depreciation, such as was enjoyed by its rival South Korea, whose exports and companies suddenly appeared unassailably competitive versus Japan following a 30% depreciation in the Won. 

Revived export competitiveness notwithstanding, investors are rushing into domestic reflation plays, with surging high beta broker/dealers and real estate stocks leading, and the export sectors to follow after global demand more clearly recovers.

Abenomics vs Koizumi Rally

Source: TSE, JapanInvestor

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Time to Bail on the Hottest Trade (Short Yen, Long Nikkei) This Year?

Investors are Dumping Inflation Hedges

The noticeable shift in sentiment suggests the market may be approaching a breaking point where investors give up on the notion that the economic recovery is accelerating and/or that inflationary pressures are rising.

Since global financial stability slowing continues to improve (as confirmed by recent IMF statements), what we are talking here is not another look into the abyss, but a reality check, where “excessive” investor expectations for growth and inflation are again squeezed out of market prices. While “acute” global financial stability risks have been reduced, the Eurozone has an ongoing debt and credit problem that is suffocating economic growth and thus corporate and bank balance sheet repair in the region remains spotty and uneven, leaving a sword of economic and financial stability hanging over the region. The following are some yellow flags that markets (investors) are beginning to “smell” deflation.

Yellow Flag 1: Investors dumped their holdings of TIPs (Treasury Inflation-Protected Securities) last week following a weak auction of 5-year notes. Falling prices prompted a spike in yields on the TIPS, which ostensibly hedge against inflation. Traders observed that, “the rest of the TIPs market is having a mini implosion since the auction, as real yields on TIPs have jumped 8-10bps across the curve in what appears to be a ‘get me out’ trade. The spread between the yield on TIPS and the yield on plain vanilla Treasurys, or break-even rate, which dictates the rate of inflation necessary for TIPS to provide a better return, has been in free fall. Before the auction, the rate was at roughly 2.24%.

Yellow Flag 2: Commodity prices are selling off. While the financial media was focused on the first weakness then sharp selloff in gold, significant selling was also underway in other commodities more closely linked with the real economy. The CRB index has quickly sold off some 7.9% from a 2012 high and is still over 24% lower than its 2011 post-crisis high. Copper has recently sold off just under 14% and is 30% lower than its post-crisis high, while crude oil (Brent) has sold off over 11% and is also about 24% below its post-crisis high.

In the week ended April 9, investors unloaded the equivalent of about 20 million barrels of oil in U.S. petroleum contracts, according to the CFTC’s Commitments of Traders data. Bloomberg data indicate indicate hedge funds and other money managers cut their bullish bets on Brent to their lowest level in four months, while a separate survey by Bloomberg shows investors expecting US crude supplies to hit a 23-year high of over 390 mm/bbl.

Since bottoming in October 2012, inventory levels of copper have risen 190% in warehouses operated by the London Metals Exchange. That’s a huge and rapid increase, and it conveys a powerful message about the future for copper prices. We are seeing an even more rapid rise in inventory levels than when global demand collapsed in 2008, and it comes on just a small amount of drop in copper prices. 

Yellow Flag 3: Great rotation not. Despite all the talk of the “great rotation” from bonds to stocks, global bond yields have taken another leg downward, with the German 10yr bund recently falling 50bps to 1.25%, the 10yr US treasury dropping 38bps to 1.68% and of course Japan’s 10yr dropping 39bps to historical lows at 0.45%. Even Spain’s 10yr bond yield continues to decline, by a large 238bps to 4.64% from July 2012 highs. Falling bond yields of course are another hint of shrinking growth expectations and/or shrinking inflation expectations.

Yellow Flag 4: Emerging markets have been underperforming by a widening margin since late 2012, ostensibly because of softening economic data, weakening commodity prices and slowing capital flows.

The Gold Crash Whodunit

The $20 billion gold futures sale and concentrated selling of gold futures on the US COMEX on Friday and Monday has gold bugs shouting “conspiracy” as they smelled manipulative selling by a large hedge fund, bullion bank or even the Fed, behind the crash. The CFTC is scrutinizing whether gold prices are being manipulated, although they public state that the drop doesn’t necessarily mean “anything nefarious”. The CFTC said in March that it is looking at issues including whether the setting of prices for gold—and the smaller silver market — is transparent and if it is fixed.  Blackrock said it saw“no visible central bank activity” although the reported sale of (USD400 mm) gold by Cyprus was supposedly one trigger for the selloff.

Selling of paper gold ETFs backed by real gold probably accelerated the move. This is because GLD shares are dumped at a quicker pace than gold’s own selloff, creating an excess supply of GLD shares, forcing GLD administrators to buy up this excess supply, and raising cash to do this by selling gold bullion. According to Zeal LLC, the recent “correction” in GLD’s holdings forced it to dump a staggering 169.8 tons (5.5 million ounces) of gold bullion simply to keep GLD shares’ price tracking gold! There are only two gold-mining companies in the entire world (Barrick and Newmont) that produce that much gold in a whole year. The drop capped a trend of declining global gold investment (including bars, coins and ETPs), as the World Gold Council saw an 8.3% drop to 424.7 tons in 4^th QTR 2012.

George Soros and Louis Moore Bacon reportedly cut their stakes in gold ETF products last quarter, for Soros by 55% as of December 2012. Once heavily long gold, hedge funds reportedly cut bets on a gold rally by 56% since the yellow metal reached a 13-month high last October. As hedge funds headed for the exits, the investment banks turned bearish. SocGendeclared the gold era was over and set an end 2013 target of USD1,375, near the time that Citigroup declared the end was nigh for global oil demand growth (on substitution natural gas for oil combined with increasing fuel economy).

Goldman set a year end target of USD1,450 and said it could go lower, then nailed the selloff with  a “short gold” recommendation a week before gold really tanked. This selling came amidst a consensus among economists that economic growth would accelerate in the U.S. and China in the coming quarters, according to Bloomberg and other surveys.

Gold has Lost its Safe Haven Status?

Soros total the South China Morning Post, “Gold has disappointed the public”…”when the Euro was close to collapsing in the last year…gold was destroyed as a safe haven, proved to be unsafe…Gold is very volatile on a day-to-day basis with no trend on a longer-term basis.” While Soros was long gold big time until fairly recently, he called gold “the ultimate bubble” in February 2010, implying he would enjoy the momentum ride until the music stops.

It is puzzling that gold crashed just as the BoJ was unleashing its “shock and awe” monetary expansion that will double Japan’s monetary base from Y138tn or 29% of GDP at the end of 2012 to Y270tn or about 54% of GDP by the end of 2014. This compares to a US monetary base expansion of 6% GDP in mid-2008 to 19% of GDP by this March. The BoJ’s increase in balance sheet of Y5.2tn (US$54bn) per month in 2013 is the equivalent of annualised 13% of 2012 GDP, or roughly twice the Fed’s current balance sheet expansion, at annualized 6.5% of 2012 US GDP.

If the real reason for the gold crash ends up being “rogue” shorts by Goldman, Morgan Stanley or JPM, etc. traders swinging for the fences that eventually blows up in their face, we may have a more serious problem than realized.

Source: 4-Traders.com

Is the Recovery Bull Market Already Long in the Tooth?

Looking at every bull market in the US since 1871, the historical “average” bull market lasted 50 months, with a media gain of 123.8%. The range since 1970 however has been substantial, from 32 to 153 months in duration, and gains ranging from 56.6% to over 516%. There is of course no way of knowing whether this bull market will be a short one or a long one, but coming out of the 1930s depression, there were no less than four bull markets ranging from 140% to 413% gains. For our money, this bull market is reaching a historical median milestone has no particular significance. 

Hat Tip: Big Picture

Economic Surprise Index Turns Negative 

In addition to the disappearing inflation premium in TIPs, we believe the negative turn in Citigroup’s Economic Surprise Index is having an impact…i.e., investor expectations were overshooting what it now appears the recovery is able to deliver. This is a marked contrast from the June 2012 to November 2012 period, when investor expectations were low and the economic data was surprising on the upside despite investor concern about the Eurozone and the US budget impasse. Given that US sequestration has kicked in, know one should really be surprised that the US economic data is looking “squishy”. 

The March US jobs report (which came in at just 88K) was an example of disappointing weakness, accompanied by some weak U.S. housing and retail data. Building permits have declined since January. Single family starts were down 4.8%. Homebuilder confidence, which climbed to its highest level (47) since 2006 in December, stalled in January 2013 after an eight-month rise and fell to 42 in April. Foreclosure starts have also begun to pick up again.

Source: Citigroup

The IMF Lowers its (Too Optimistic) Global Growth Forecast 

The IMF lowered its 2013 global growth forecast, to 3.3% from 3.5% and its 2014 forecast to 4.0% from 4.1%, reflecting, 

a) Sharp fiscal spending cuts in the U.S. (sequestration, etc.) should shave about 0.3 percentage points from US GDP this year, 

b) Struggling, recession-striken Europe, with economic contractions in France, Spain and Italy expected this year. 

c) With the IMF was upbeat on China, mediocre growth here is sparking concerns that growth is slowing. 

d) The good news was that the IMF raised its forecast for Japan, ostensibly on the BoJ’s aggressive new monetary stimulus. 

To IMF cynics, these downward revisions haven’t gone far enough, particularly as regards expected inflation. 

US Commerce Board Suggests US Economy Has “Lost Some Steam” 

The economy “has lost some steam” and will grow slowly in the near term, the Conference Board said Thursday as it reported that its leading economic index ticked down in March. The LEI declined 0.1% last month, following three months of gains, and economists polled by MarketWatch had expected the index to rise 0.2% in March. In February, the LEI rose 0.5%. The largest negative contribution came from consumers’ expectations. Other negative contributions came from building permits, a manufacturing new-orders index, weekly manufacturing hours and weekly jobless claims. 

Goldman Sachs’ Business Cycle Indicator Goes from Bad to Worse 

The latest Goldman GLI (global leading indicator) shows that the situation has gone from bad to worse. Consumer confidence, global PMIs, and industrial metals have all worsened significantly, pushing the Global Leading Indicator momentum down. Goldman’s GLI also points to future deterioration in global industrial production. 

Hat Tip: Zero Hedge

The Spring Equities Swoon Revisited 

The disconnect was that while the economic data flow was increasingly falling below expectations, bond yields were falling not rising, the TIPs inflation premium was shrinking, and commodities were selling off, the S&P 500 was blithely ignoring this in hitting a new rebound high.

Over the past several years, investors have repeated a pattern of beginning the year with optimistic U.S. growth/recovery expectations, only for these expectations to evaporate by mid-year as waning data suggest sluggish activity, which has contributed to a “sell in April-May” and go away pattern in stock prices as investors fretted about a) a possible end to QE, b) sputtering economic growth and c) ongoing Eurozone crisis. 

Yet, in “selling in May and going away”, investors would have missed most of the next up-leg that took the S&P 500 to new recovery highs, with the entire move from the March 2009 low of 683.38 now representing a 132% gain over a period of just over four years. This time, the correction could be essentially the same, i.e., basically a reality check that does not seriously endanger the post great recession, QE fueled market recovery. While the apocalyptic bears are still out there, their hyperbole is somehow less believable than in 2011 or 2012.

Source: Yahoo.com, JapanInvestor

Short-Term Breakdown in S&P 500 

In addition to the yellow flags previously mentioned, cracks are forming in the S&P 500 rally itself. 

The S&P 500 index is recently unable to close back above its 50-day moving average. This is the first close below this key price level in 2013 as high-beta Tech (AAPL) and Homebuilders underperformed notably. Stocks are below Cyprus levels and marginally above Italian election levels. 

Hat Tip: Zero Hedge

The Trend is Still Your Friend 

The so-called momentum effect is one of the strongest and most pervasive phenomena of any market phenomenon studied. Researchers have verified its value with many different asset classes, as well as across groups of assets. The momentum effect works in terms of asset’s performance relative to its peers in predicting future relative performance, and momentum also works well on an absolute, or time series basis, where an asset’s own past return predicts its future performance. In absolute momentum, there is significant positive auto-covariance between an asset’s return next month and its past one-year excess return. Absolute momentum appears to be just as robust and universally applicable as crosssectional momentum. It performs well in extreme market environments, across multiple asset classes (commodities, equity indices, bond markets, currency pairs), and back in time to the turn of the century.

In short, the trend is your friend until, like was seen in gold, it is decisively broken. 

Foreign Investors Pile Into Japan

Having ignited a virulent “short yen, long Nikkei trade”, Shinzo Abe and his BoJ buddies continue playing the market psychology game to the hilt, knowing that a change in consumer, corporate and investor sentiment can be just as good as “real” change through what George Soros termed reflexivity.  Japanese policymakers know full well that public expectation of more deflation can become self-fulfilling, and they are actively trying to change the way ordinary Japanese think about prices, just as they have engineered a dramatic turnaround in foreign investor sentiment. 

They see the fight against deflation not just as one that involves measures like quantitative easing, but also psychic warfare: Once Japan’s consumers and business leaders believe prices will start rising, there’s a better chance people will go out and spend, putting pressure on prices to go up. 

Ryuzo Miyao, a member of the Bank of Japan’s policy board, has actually said that deflation will end in the current fiscal year (to March 2014). “The achievement of 1 percent inflation in fiscal 2014 has come into sight,” Miyao said. “The public’s inflation expectations will rise gradually, and in this situation the inflation rate is likely to rise above 1% during fiscal 2014.”

While Piling In, They Also Discuss Possible Loss of Control By the BoJ

For many years very underweight and generally very pessimistic about Japan, foreign investors have piled into Japanese equities since November of last year, and this buying accelerated to a record weekly figure last week, according to the Tokyo Stock Exchange. A new net buying record of JPY1.58 trillion was set in the second week of April, after the Bank of Japan unveiled new “shock and awe” quantitative and qualitative easing measures under newly installed Governor Haruhiko Kuroda. The new data put cumulative net purchasing by foreign investors since mid-November, when the decision to dissolve the lower house was made, at JPY8.15 trillion.

Source: Nikkei Astra, Tokyo Stock Exchange, Japan Investor JPY Billion

At the same time, they continue to discuss the probability that the Bank of Japan (BoJ) would lose control of the printing press and how a rapidly declining yen could lead to a replay of the 1997 Asian currency debacle. Perma bear Albert Edwards points out that investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse. 

Japan Becomes Extremely Overbought

Regardless of whether the big Abenomics/BoJ bet eventually pans out, the following chart from Orcam Financial shows the Nikkei as the most overbought (i.e., above its 200-day MA) and Gold the most oversold, suggesting there is now ample room for a short-term mean reversion trade between the two (like short Nikkei, long gold), and this big contrarian call is exactly what CLSA strategist Chris Wood is now suggesting.

Hat Tip: Pragmatic Capitalism

The call is predicated on the non-belief that the US economy is “normalizing” and US QE will come to an end earlier than what investors currently expect. Indeed, it counts on the conjecture that the BoJ’s bold move on QE is not the last by a long shot. For one, Mario Draghi at the the ECB would love to do more if he thought he could get it by Germany. Support for this view comes from three regional Fed bank presidents saying a further decline in US inflation below the Fed’s 2% target may signal a need for more accomodation, not a potential curtailing of easing discussed by other Fed officials. 

Other brokers are beginning to suggest the Topix/Nikkei 225 is due for a 10% or so pause from the parabolic move upward since November of last year. In looking at individual stocks and sectors like Sumitomo Realty (8830.T) and the real estate sector as a whole, prices have already surged to Koizumi reform years peak levels, meaning a lot of the expected reflation for the foreseeable future is already priced in, given that Sumitomo Realty for example is already selling at a very rich P/E of 43X and a PBR of over 4X.

The Japan equity rally has been driven primarily by Nikkei 225 constituents, i.e., larger cap, more liquid names that foreign investors found the easiest to quickly raise their Japan exposure. However, the core 30, which includes more than its share of troubled electronic sector and other “dogs” continues to lag by a considerable margin. 

Source: Nikkei Astra, Japan Investor

The best year-to-date performers in the Nikkei 225 include many real estate companies, both first and second-tier, major retailers, second-tier financials, heavy industry stocks and even a couple of pharmaceutical companies.

Over the past month, however, buying has gone from “all in” to more specific sector and stock selection, amidst continued selling by domestic financial institutions who see this as an ideal time to unload unwanted strategic holdings. The biggest irony is that the electric power “zombies” are on the leader board. while the bank sector has taken a breather. The growing sector divergence is indicative of the emergence of quick sector rotation. 

Source: Tokyo Stock Exchange, Japan Investor

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Crashing Gold, Falling Commodity Prices: End of the Commodity Supercycle Bubble?

The Gold Bubble Pops

When a financial market “bubble” first collapses, there is often no immediately compelling reason.     The real reasons/rationalizations for the collapse come afterwards. Gold’s last bubble was in 1980 when it hit $800/ounce in nominal terms, and $2,187/ounce in 2009 US dollars. While the entire bull market lasted some 11 years, when gold moved over $700, it stayed there just a couple of weeks before plunging to the $300~$500 range. 

Source: True North, via Seeking Alpha

On Monday, gold futures for June delivery closed at $1,361 an ounce on the Comex in New York , a drop of more than $200 in two sessions, and the fall of 13% since April 11 was the biggest two-session decline since 1980. The dream of $3,000/ounce or even $2,000/ounce, so prevalent not so long ago, is over. In other words, the great bull market in gold is over. The GLD ETF briefly was the world’s biggest ETF, with assets north of $77 billion in August 2011, topping the SPDR S&P 500 ETF (SPY) for a time. Recently, the GLD ETF has suffered such intense differential selling pressure that its custodians have been forced to dump enormous quantities of physical gold. This is because GLD shares are dumped at a quicker pace than gold’s own selloff, creating an excess supply of GLD shares, forcing GLD administrators to  buy up this excess supply, and raising cash to do this by selling gold bullion. According to Zeal LLC, the recent “correction” in GLD’s holdings forced it to dump a staggering 169.8 tons (5.5 million ounces) of gold bullion simply to keep GLD shares’ price tracking gold! There are only two gold-mining companies in the entire world (Barrick and Newmont) that produce that much gold in a whole year. 

Source: 4-Traders.com;

While Some Suspected Trouble Ahead for Gold, No One Knows How Far its Going Down Now

One of the first investment banks to officially turn bearish, SocGen declared the gold era was over and set an end 2013 target of USD1,375, near the time that Citigroup declared the end was nigh for global oil demand growth (on substitution natural gas for oil combined with increasing fuel economy). Goldman set a year end target of USD1,450 and said it could go lower, then nailed the selloff with  a “short gold” recommendation a week before gold really tanked. What did Goldman know that others didn’t? 

Bloomberg Businessweek attributed the rapidly fading interest in gold to the realization that inflation was under control and falling despite “totally irresponsible” monetary policies that were rapidly eroding the value of fiat currencies. The JPMorgan Chase global consumer price index (covering more than 30 countries and 90% of global output) showed inflation peaking at 4% in 2011 and falling steadily since, while February 2013 prices were up only 2.5%. Bloomberg in another article blamed the selloff on, a) optimism that a U.S. recovery will curb the need for stimulus and b) the prospect that beleaguered members of the euro zone might be forced to sell gold to raise part of the funding, and there are much bigger holders in that category than Cyprus. Citigroup offered that the selloff was related to a break in technical levels and the general improvement in global risk appetitite. Business Insider argued that gold’s collapse “vindicates the economic ideas of the economic (Keynesian, monetarist) elites. BigPicture blogger Barry Ritholtz opined that “Gold is the ultimate greater fool trade, with many of its owners part of a collective belief theory rife with cognitive errors and bias”, that after a 14-year monster rally. 

But these explanations smack of rationalization, not an analysis of what really triggered the selloff. 

Has investor risk appetite and confidence in global economic growth and declining financial sector risk improved that dramatically in the last few weeks? Did investors wake up one morning and suddenly realize there was no global inflation? Only a short while ago, gold was touted as set to rebound with the BoJ’s massive QE program and the inevitable response by other central banks. Europe remains in the intensive care unit, despite the protestations of its leadership and the indications of its nepotistic bond markets. Monetary operations have enhanced liquidity, but have done little-to-nothing to solve the real issue – which is insolvency. 

Gold bugs of course remain bullish on gold to the end, insisting the selloff was soley in the paper gold market while pointing out there is a shortage of physical gold, and insisting that investors shouldn’t be concerned about the “temporary” pressure on gold. But since last Friday, someone has wanted to dump a large position of gold very badly. 

Someone who writes under the name George Washington on the Zero Hedge site quoted London bullion dealers observing that the gold futures market in New York on Friday last week saw a massive 3.4 million ounces (100 tons) worth of selling in the June futures contract, that was soon followed by 10 million more ounces (300 tons) of selling in the next 30 minutes of trading that looked suspiciously like short selling. Conspiracy theorists think the Fed was manipulating the gold market, claiming the 500 tons of naked shorts last Friday were instigated by the Fed. 

Brokers (Goldman, etc.) were reportedly warning their clients the word was out that hedge funds and institutions were going to be dumping gold. Others blamed the Japanese. 

End of the Commodity Supercycle?

In fact, no one knows for sure, and that is what is disturbing. Rapidly rising bullion prices were ostensibly a manisfestation of loss of confidence in the dollar as well as other fiat (paper) currencies, and a reflection of expectations for even more fiat currency depreciation, as well as fears that the Eurozone would simply fall apart. As the BoJ uncorked its massive QE, gold was supposed to take off again. But the ECB’s balance sheet is now actually shrinking, and the Fed is talking about possible exit strategies–possibly leaving the BoJ as the last to the party. Gold actually may be reading the dotted line in the chart below going down, not up. 

Hat Tip: Zero Hedge

Its not only gold, but the whole commodity complex. The CRB commodity index peaked in 2007 on booming global trade after a 2-year, 65% blowoff, then crashed when the global financial crisis hit. Commodity prices then rapidly re-inflated on massive QE, liquidity provision from central banks to a secondary peak in 2011, ostensibly on the assumption that all of this money printing would inevitably unleash inflation, but is now some 40% below the 2007 high. 

Source: 4-Brokers

“Dr.” Copper Rally Fizzles

The Wall Street Journal is reporting that two major commodities-trading firms have amassed much of the world’s copper supplies in their warehouses, partly by paying to divert shipments away from other storage hubs, traders and analysts say. Copper prices are near 8-month lows and more losses are expected. Until the latest selloff, prices were down around 6% YTD as inventories have steadily climbed while demand in China has been disappointing. The Thomson Reuters GFMS sees copper dropping to as low as US$6,500/t in 2013 as high warehouse inventories and weak demand from Europe and China pin down prices. So much for copper calling a major recovery in the global economy. 

Source: 4-Brokers

Crude Oil Too

As previously mentioned, Citigroup has already declared the end was nigh for global oil demand growth on the substitution of natural gas for oil combined with increasing fuel economy.  Like the GLD ETF, selloffs in the copper and oil commodity investor ETFs will force further selling of the underlying commodity. 

Source: 4-Traders

What Does Commodity Selloff Tell Us About the Real Economy and/or Stock Prices?

The experience of most investors today (with the exception of  Japanese investors for the past 20 years) is within an environment of inflation and growth, and they naturally believe that long-term bond yields have a positive correlation with commodity prices because of what commodity prices are signalling about future inflation. They have also been conditioned to believe that bond yields and stock prices are positively correlated. 

Neither however has been true since before the financial crisis. 

1) Commodity Prices and Long Term Bond Yields

From 1980 until the spring of 2002, 10-year Treasury bond yields had a positive correlation with the CRB index. Since 2002, however, there has been a dramatic divergence between Treasury yields and commodity prices. The general assumption heretofore is a) that the 1980~2002 bonds/commodities relationship is valid, and b) the divergence is unsustainable. The assumption was that bond yields must eventually rise to meet the “real trend” in commodity prices, as commodity prices are a leading indicator of inflation, and bond yields discount both expected growth and expected inflation. 

But the recent selloff in commodities is strongly suggesting this assumption is wrong, and that any notion that the massive QE being practiced by the developed country central banks is inflationary is equally wrong-headed. As Cullen Roche of Orcam Financial (and other modern fiat monetary system theorists) has consistently maintained, QE is essentially just an asset swap that changes the composition of private sector financial assets, and doesn’t increase net financial assets in the private sector. While QE has had some impact on artificially lowering rates and a significantly positive psychological impact on stock prices, QE in and of itself does not cause inflation. If this is true, commodity prices are now marking to bond yields, not the other way around.

Source: Yahoo.com

2) Bond Yields and Stock Prices

How about the relationship between stock prices and bond yields? Until around 1985, long-term bond yields in the U.S. were positively correlated with stock prices. After 1985, however, stock prices have become negatively correlated with bond yields. As the SP 500 renews its pre-crisis highs, long-bond yields continue to decline, meaning bond prices and stock prices are both rising as inflationary expectations wane. 

Source: Yahoo.com

Since bond yields discount both expected inflation and GDP growth, the current US 10-year bond yield of 1.71% would seem to be essentially discounting, a) no inflation and under 2% GDP growth, or b) minimal inflation and GDP growth of just +/-1%, while the US stock market appears to be discounting much higher GDP or at least corporate profit growth. If 2%+ US economic growth is actually a myth and does ever collapse, look out below for stock prices, as investors wring out unrealistic growth expectations from stock prices in a manner similar to what has happened in Japan over the past decades. 

Gold Selloff Bearish for Nikkei 225, Bullish for JPY

Japan’s Nikkei 225 has historically displayed a positive correlation with gold prices and an even tighter positive correlation with US 10-year bond yields. Here again, we are seeing a growing divergence because of “artificial” policy initiatives, as Abenomics has dramatically depreciated JPY while US bond yields remain subdued. 

Source: Yahoo.com

The Nikkei 225 has recently been moving in lock-step with JPY/USD, even though the focus of the actual Japanese stock buying has been on domestic reflation plays, not the exporters. The rout in gold has quickly pushed JPY/USD three yen stronger than the recent low of just under JPY100/USD, which had paused on a warning from the US Treasury department that Japan abstain from “competitive devaluation” of JPY. 

Source: Yahoo.com

As long as the Japanese government and BoJ are aggressively working to reflate Japan and weaken JPY, the slippage in the traditional JPY/USD driver, i.e., the spread between 2-year Japan and US bond yields and JPY/USD, is likely to persist. Whether the BoJ’s actions can weaken JPY back to 2007 levels (around JPY124/USD) however remains to be seen given increasing concern about a competitive devaluation of JPY. 

While economic historians are still arguing about just what part of Koreikyo Takahashi’s policy mix (i.e., fiscal expenditures, BoJ purchases of JGBs and currency weakening) in what Ben Bernanke praised as brilliant, we posit that what worked the most in both Takahashi’s and FDR’s efforts to reflate Japan’s and the US economy in the 1930s was a substantial depreciation (40%) of the currency, which in both cases amidst the gold standard economic “religion” at the time considered unmitigated blasphemy. 

Domestic Bond Investors are Confused: Does the BoJ Really Want to Keep Rates Low or Boost Inflation to 2%? They are Having Trouble Getting Their Head Around Both

Japanese bond investors are also very confused about what Kuroda’s 2% inflation commitment really means for JGB yields. “Essentially we now have a national policy that says investors should buy risk assets by borrowing cheaply. So if you think interest rates will be higher two years from now, you would have some hesitation in buying anything longer than five years,” said Hidenori Suezawa, chief fixed income strategist at SMBC Nikko Securities as quoted through Reuters. Japanese bond investors“simply cannot grasp what the BOJ is getting at,” said Katsutoshi Inadome, fixed income analyst at Mitsubishi UFJ Morgan Stanley Securities, also via Reuters. Assuming Japan can achieve 2% inflation and stimulate Japan’s economy to achieve 2% growth, JGB yields should ostensibly rise to around 4% if investors really believed the BoJ can pull it off. Since this would essentially blow up Japan’s public finances, the BoJ has committed to buying essentially 1.5% of Japan’s GDP in JGBs indefinitely to prevent JGB yields from discounting this possibility. 

What’s the BOJ’s priority? Keeping rates low or boosting inflation to 2%? If it is the latter, buying five-year bonds yielding 0.2% would be a disaster for domestic investors. This uncertainty and lack of confidence is what is causing a sharp surge in government bond market volatility.

Tokyo Quickly Regains Composure After US Selloff

Despite waking up to bad news of a significant US selloff and a sharp reversal in JPY/USD overnight, the Tokyo market quickly regained its composure, with the Nikkei slipping only 0.4% and JPY/USD re-weakening. With Abenomics now in full force, Japanese stocks are much less susceptible to overseas market volatility. Any short-term correction (and not a collapse) in US stock prices will be viewed as a chance to add some more exposure to Japanese equities.

Our concern however is that the domestic reflation plays have already surged in parabolic fashion to the Koizumi reform highs, whereas we do not see the Nikkei 225 as being able to seriously breach the prior 18,000+ plus Koizumi high (in 2007) without evidence that a restructuring/re-invention wave is underway in Japan’s economy, as we see restructuring/re-invention as the real driver of sustainable growth in Japan going forward. In other words, the first two “arrows” of Abenomics, i.e., bold monetary policy and more active fiscal policy, as basically buying time for structural reforms to adjust Japan’s economy to a new world order.   

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

What’s Happened to the Price of Gold?

The price of gold is falling while the price of Bitcoin, a new cyber money, is surging. What’s happening?

Source: Yahoo.com

The GLD gold SPDR chart has broken down, with the daily price now not only below the 200-d EMA, but a “death cross” already having been formed between the 50-d and 200-d EMA, indicating an extended correction. If this is a moderate correction like that seen mid-2012, GLD is near support, and it is indeed trying to rally off this support, albeit not yet too successfully. 

The first (and most important?) is real interest rates that are ticking up.  When real interest rates are extremely low or falling, gold is usually rallying, but when real rates are rising, the gold rally fizzles.

Hat Tip: Business Insider

The other gold price stimulate is fear, this time as measured by the S&P 500 VIX volatility index. When investors are fearful and in “risk off” mode, the VIX surges and with it, gold. 

Hat Tip: Business Insider

Thirdly, there is the strength in USD, which to us is a weaker excuse for the selloff, as the momentum in gold has been downward since 2011. Despite the QE blitzkrieg, USD has not collapsed and has ceased to be a “risk off” proxy.

Source: Yahoo.com

In fact, USD has had a definite upward bias over the past year, while JPY, GBP and EUR have been collapsing, thanks to a more resilient economy and the greater need for more QE in Euroland and certainly in the U.K. and Japan. 

Source: Yahoo.com

Gold is now declining not only against the big fiat currencies like USD, EUR, GBP, CHF and AUS$, but also against the falling JPY. 

Source: Kitco

The “gold guys” (this time, Kitco) explanation is a bit different. They say gold has been supported by gold bugs and their followers due to an incorrect monetary assessment. According to Kitco, the gold community was divided into two camps: a) those that believed in an inflationary depression, and b) those that believed in a deflationary depression. So far, we have seen neither, and gold bulls are losing patience. The Fed’s ramping up of money supply hasn’t materially goosed inflation, nor is a new great depression appear imminent. Gold bulls began to reduce their holdings of gold stocks, then gold itself, as monetarists claims that new money printed by the Fed would show up as inflation within 9 to 18 months failed to pan out. Even the inflation bulls have had to admit that there is no theory that states that inflation will soar after four years of increasing the money supply.

In terms of investor demand for gold, the big hedge funds (Soros, Paulson, etc.) are unloading what once was their favorite position, reducing the “investment” demand for gold. More controversial is the tailing off of financial panic in the Eurozone. Periphery insolvency notwithstanding, deflation and recession is the nemesis as de-leveraging continues.

Bitcoin Just a Sideshow

Some (like Max Keiser) have suggested gold’s problems are at least in part attributable to the Bitcoin phenomenon. Ostensibly, more and more people are discovering that Bitcoin is indeed money. At a market value of some USD1 billion plus, however, it is a drop in the bucket for even the relatively smaller (versus the stock and bond markets) gold market. Bitcoin is best described as a virtual crypto/digital parallel currency that is completely decentralised and unregulated for now.

We agree with the FT view that Bitcoin is the “fiat of all fiats”, “due to its decentralised fiat nature and because its value lies in the mutual interests of its users rather than a collateral pool.” “The community is kept together by mutual interests related to counter culture, subversion or even criminal objectives — not dissimilar to a pyramid or a ponzi.” To us, Bitcoin looks like something right out of Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds”

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japanization, Gold, The Great Rotation and the Short Yen Trade

Ben Bernanke on Why Long Rates are So Low 

Why are long-term interest rates so low in the United States and in other major industrial countries? In a nutshell, growth expectations are low—as per Ben Bernanke; “Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low…The similar behavior of these yields attests to the global nature of the economic and financial developments of recent years, as well as to the broad similarity in how the monetary policymakers in the advanced economies have responded to these developments.”—i.e., with lots of “quantitative” easing.

Greenspan’s Legacy of Dramatic Interest Rate Cuts

To many, previous Fed Chairman Alan Greenspan’s legacy is of dramatic interest rate cuts and bubbles, ostensibly to a) restore investor confidence in financial markets from October 1987 crash., and b) to prevent the US from falling into deflation after the IT bubble collapsed in 2000, Greenspan slashed interest rates successively in an effort to revive the markets and economy from a post bubble malaise. When short term interest rates reached sixty year lows of 1% and the economy was still languishing, Greenspan tried a new tactic in 2003, claiming that he was concerned about the possibility of deflation and was prepared to take extraordinary measures to prevent its occurrence, since the last time deflation hit the United States the country was mired in the depression of the 1930’s. While the collapse housing bubble and predator’s ball of toxic housing debt derivatives of course was the trigger for the 2008 financial crisis and subsequent “Great Recession”, the U.S. and Eurozone had already caught the Japan disease of secularly declining bond yields BEFORE the 2008 financial crisis.  

Lowest 10-Year Bond Yields in 220 Years!

But long-term bond yields for the developed nations were declining long before the 2008 financial crisis. Indeed, long-term rates had already halved BEFORE the crisis and extraordinary central bank monetary policies. This implies that inflation has remained low and stable for over a decade and expected growth rates are in a secular decline. In fact, US long bond yields are the lowest they have been in 220 years! Basically, the massive spike in long bond yields during the 1970s was a massive aberration not seen in over two centuries of economic history. It is also interesting to note that, prior to the big surge in bond yields from the 1950s, US long bond yields had been in a secular downtrend since before the 1800s. As the chart below of long bond yields since the 1800s shows, spikes in interest rates tended to be the exception, rather than the rule. 

Source: US Federal Reserve

The Three Drivers of Long Bond Yields

The wonkish (Bernanke) view is that long-term rates can be decomposed into a) expected inflation, b) expected direction of short-term real rates, and c) a term premium. All three components of the 10-year yield have declined since 2007. The expected inflation component has drifted gradually downward for many years and has become quite stable, which the Fed attribues to “the  increasing credibility of the Federal Reserve’s commitment to price stability”. The decline in expectations for real short-term rates is again ostensibly due to monetary policy, which in turn is driven by the economic outlook and the risks to that outlook. The term premium is also explained as the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period. The downward movement here is attributable to, a) the declining volatility of Treasury yields, and b) the growing negative correlation between bond yields and stock prices, as bonds are valued more highly as a hedge against the perceived risk of holding other assets. The Fed also took credit for affecting this term premium with a series of Large-Scale Asset Purchase (LSAP) programs.

Bernanke insists that since, “the major industrial economies apparently cannot sustain significantly higher real rates of return; in that respect, central banks–so long as they are meeting their price stability mandates–have little choice but to take actions that keep nominal long-term rates relatively low”, and finally push real long bond yields negative. 

Source: US Federal Reserve

The Deathbed of Post Great Depression Keynesian and Monetarist Policy?

The author of all the economic textbooks currently active public and private sector economists learned economics from in school was Paul Samuelson, whose writings tried to synthesize Keynesian economics with neoclassical economics, as embodied in the  IS/LM model (Investment—Saving / Liquidity preference—Money supply) model. The IS/LM model criticizes Keynesian deficit spending as a means of stimulating the economy because it supposedly crowds out the private sector and private fixed investment. It praises monetary stimulus on the other hand because it lowers interest rates and raises economic income. 

With the global financial crisis in 2008 caused a resurgence in Keynesian thought, the Great Recession and its aftermath represents one of the most serious tests ever of an economic philosophy that has endured for over 80 years. Nobel laureates Joseph Stiglitz, Robert Solow and Paul Krugman, all dyed in the wool Keynesians, are among a group of economists insisting that deficit spending was the only way to salvage the U.S. and U.K. economies, As a group, the new Keynesian economists ostensibly agree with the new Classical economists that in the long run, changes in the money supply are neutral. 

This notwithstanding,  the heavy lifting has fallen on monetary policy to a) first stabilize shaky financial systems and then b) stimulate output and employment. This is because the developed nations got themselves into a debt pickle through repeated bouts of fiscal largesse to soften economic downturns over the last half-a-century, while ignoring the second half of the Keynesian approach, which was to deflate the economy iand reduce debt n booms. Meanwhile, monetary policy is rapidly painting itself into a similar corner. Keynesians will tell you that the reflationay policies needed to boost economic activity include,

1) Increasing government expenditures to offset slowing private sector expenditures (fiscal policy).

2) Cutting taxes (direct or indirect) to encourage spending (fiscal policy)

3) Cutting interest rates to discourage saving (monetary policy)

4) Boosting the money supply, ostensibly to make liquidity/funding more readily available (monetary policy).

Developed country governments have embraced these fiscal and monetary policies with gusto since the last Great Depression. However, Keynes also believed that, during economic booms, governments should take policies to 

1) Reduce the level of government expenditure

2) Increase taxes (direct, indirect, or both)

3) Increase interest rates

4) Reduce money supply growth…

…Which the developed nation governments found too politically threatening to implement and/or conveniently forgot during the good times. Thus when times were good, the debt declined as a percent of GDP due to higher economic growth and inflation, but there was no serious attempt to reign in the debt. Conversely, government expenditures rose during economic downturns, and disinflation/deflation and falling government revenues greatly compounded the increase in debt during the bad times. As a result, the total amount of debt continues to rise during the good times, and soars during the bad times.

While it is obvious these formulas did not work for Japan in the 1990s, the Keynesians insist that Japan’s authorities acted with too little, too late. Yet we now have the U.K., who has been in Keynesian overdrive for the past 18 months, showing the same signs as Japan, with a budget deficit that is already more than 12% of gross domestic product and widening, while total public and private sector debt dwarfs Japan’s and the U.S. total debt, at over 900% of GDP. 

On Friday, Bernanke Effectively Told Investors to Begin Reducing their Long Bond Holdings…

To illustrate the possible path of future rates, Bernanke outlined four different forecasts of the evolution of the 10-year Treasury yield over coming years. These forecasts embody a wide range of underlying models and assumptions, but “the basic message is clear–long-term interest rates are expected to rise gradually over the next few years, rising (at least according to these forecasts) to around 3 percent at the end of 2014”, and “imply a total increase of between 200 and 300 basis points in long-term yields between now and 2017.” In other words, the Fed and other central banks are not only pushing investors into equities with rock-bottom rates and unprecedented liquidity, but also with forecasts of a substantial fall in bond prices in the foreseeable future. 

Source: Federal Reserve

...Because of the Eventual Normalization of Interest Rates

Bridgewater’s Ray Dalio calls 2013 a transition year, where investors begin to recognize the secular bottom in bond yields, and shift increasing amounts of funds into virtually all risk assets; including, ostensibly commodities. Stanley Druckenmiller is more alarmist. The Fed’s “significant rise in interest rates by 2017” scenario makes him particularly nervous. If you “normalize” interest rates to pre-QE levels (5.7%), he warns, “$500 billion a year in interest expense that goes out door. The way markets work if and when that were to happen, you don’t normalize, you keep going because the market figures out that you now have a credit problem which is exactly what’s happened in the foreign nations”–i.e., when bond prices start to go down, they are likely to go down in a big way, either by crashing or steadily falling over a long period of time. 

For years, we have argued that the fall in non-Japan developed country rates could continue for much longer than most investors could see, let alone anticipate. However, the fall in treasury yields to a new 220 year low does strongly suggest the bottom of the plunge in long bond yields since the early 1980s is near rather than far. 

Normalization of Interest Rates = Short Gold, Long Nikkei 225?

If Bernanke is right with his normalization of interest rates forecast, UBS commodity strategist Julien Garran’s prediction of a Q3 2013 major rally in gold is wrong, i.e., whether the “Fed ‘blinks first’ and stops QE, or whether the global economy ‘blinks’ and we see a slowdown in global growth momentum into 3Q13 while QE3 is continuing.” We have our money on the Goldman Sachs call, where the working thesis s that real interest rates have been driving higher gold prices. And now that those real rates have started to normalize, the jig is up for gold. Gold is now at its lowest level since 2008, while corrections of +30% during bull markets are more common than not. 

But a fundamental reversal first from negative real interest rates to “normal” interest rate levels that discount inflation expectations is a different kettle of fish, because normal interest rates also implies normal monetary policy, i.e., no more fiat currency debasement. The post 2008 uptrend is now broken, and gold has been trading sideways since 2011 as investors/speculators try to figure out if the Japanization of the US and Euroland is still alive and well, or if the U.S. in particular is in the process of escaping Japanization. 

Since JPY/USD as well as JPY/EUR is basically driven by the gap between Japan-US and Japan-EUR interest rates, normalizing US rates versus more heavily manipulated downward Japanese JGB yields indicates a widening US treasury-JGB yield gap that is a strong driver of a weaker JPY, which in turn is a major driver of Japanese stock prices. 

Thus Abenomics/BoJ Kuroda “monetary upheaval” could emerge just as US rates are normalizing, creating the perfect storm for a sustained and significant rally in Japanese stocks without blowing up Japan’s bond market. In our view, JPY could weaken to below JPY100/USD to JPY115/USD without causing the JGB market to crash, especially if investors begin to realize that Japan’s current balance of payments deficits are not structural, but very much dependent on, a) a shift from a temporary over-dependence on overly expensive imported LNG and b) a noticeable recovery in export competitiveness with the weaker JPY. 

As many brokers are pointing out, the moves so far in JPY (weaker) and Japanese stocks (stronger) are only phase one, which is the verbal phase in that what investors have actually seen of Abenomics and monetary upheaval so far has been only talk. The second phase will be how investors react to specific reflation measures and the new “I got QE religion” BoJ. Abes biggest step so far has been to pick the kind of BoJ governor successor that the Street has been clamoring for. Kuroda has not wasted any time in saying he would consider bringing forward open-ended purchases, due to start next year, and to make his stance clear that we (the BoJ) “will do whatever we can do” to eradicate deflation in Japan. The third phase will be the actual effectiveness of reflationary measures combined with structural reforms to ensure the reflationist measures are not just a transitory phenomenon. 

Since so much hot money was made on phase 1 by shorting JPY and going long the Nikkei 225, some contrarians are already suggesting that Abenomics has already created unrealistic expectations that cannot realistically be met, in which case the next move by the fast money couldl be to try and short Nikkei 225 and go long JPY. We however suspect there is more to this Abenomics thing than just rhetoric, as Abe has been listening to his advisors warnings that Japan is running out of time to do something about its malaise and rapidly growing debt burden. Speed is of the essence, a crucial point which does not seem to be lost on Abe. He is quickly following up his early verbage with action, including his pick of BoJ successors.

Biggest Risk is in Euroland, Not Japan

The biggest risk we can see to Abenomics is not in its execution, but that events in Japan could be crowded out by renewed concern about the Euroland mess, especially if more debt-ridden governments are forced by elections and other domestic pressure to abandon fiscal and other reforms, and spook investors into another wave of “risk off” as Southern European bond yields spiral higher and force the ECB to respond with more countermeasures. 

So far however, the negative surprise of Italian elections has only caused a blip in Italian bond yields, which remain well below prior crisis highs. 

Source: Bloomberg

Over the past three months, the Topix has surged 24.6%, led by shippers, broker/dealers, real estate, and rubber products. Since March 2009 lows, Japan’s broker/dealer and real estate sectors have now seen prices more than double.

Source: TSE, Nikkei Amsus

Relative to other developed markets in terms of USD-denominated total returns, however, the sharp rally in the MSCI Japan index looks much less impressive, and therefore the real shift to at least be neutral Japanese stocks relative to International/Global benchmarks has yet to occur. The most consistent outperformance since the big 2009 trough has been non-US EAFE markets, meaning investors also have to have good exposure to Euroland if they want to outperform the US market. 

Source: Nikkei Astra

However, global equity investors must also keep in mind that stock markets inevitably undergo an interim correction as they transition from being primarily driven by monetary policy to being driven by economic and corporate profit growth, which means that the market’s next big test remains the day when central banks, ostensibly led by the Fed, are confident enough in the economy to again risk removing extraordinary monetary policy. 

 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Central Bank Ponzi Schemes? and the Madness of Crowds

Have Central Banker Priests of Money Gone to the Dark Side?

Jens Weidmann and the boys at the Bundesbank must think their priests of money central bank peers have gone to the dark side, preaching the blasphemy of ever-escalating debt monetization, now called “quantitative easing”. Germany’s Bundesbank has become essentially the only central bank in the world that has not embraced quantitative easing, continually warning at every opportunity that rampant and gratuitous debt monetization with fiat money has become addictive as a drug, and like any drug overdose, can be fatal. 

For the other central bankers, led by the Fed, this move to the dark side is a desperate response to fiscal paralysis, dangerously fragile financial systems and malaise-ridden economies; i.e., an aggressive bet that monetary policy remains a viable　force.These central bankers have ventured out on the limb of “unconventional” monetary policy to the nth degree in first ensuring the viability of the financial system, but increasingly to trying to revive economies. Naturally, they trot out research that shows QE is having a positive impact. Research by economists at the Fed last year estimated its first two rounds of asset purchases reduced unemployment by 1.5 percentage points and staved off deflation. The Bank of England estimated in July that 200 billion pounds ($311 billion) of bond buying between March 2009 and January 2010 raised UK GDP by as much as 2 percent and inflation by 1.5 percentage points.

As former Bank of England’s Danny Gabay told Bloomberg, everything in central banker eyes is a monetary problem…“What we have now is a monetary problem, so it’s time for a monetary solution,..It’s tough to make monetary policy effective, but it’s the only way.” “Old school” central bankers like Mervyn King (BoE), Jean-Claude Trichet (ECB) and Masaaki Shirakawa (BoJ) that question how much more monetary policy can achieve, and insisting monetary policy alone is no “panacea.” are being ignored.

No Currency Wars, Just a Symptom of Increasingly Desperate Stimulus Measures

The respected, conservative Economist magazine outright dismisses the current buzzword “currency wars” to describe what is happening, because weak currencies are merely a symptom of so far ineffective but increasingly desperate central bank efforts to revive economies stumbling under an ever-growing albatross of government debt. The recent round of GDP growth numbers underscores the continued fragility of the recovery, with Japan recording its third quarter of minus growth, and GDP being noticeably weak in Euroland, even Germany; underscoring the cold hard fact that all that QE is just about the only thing standing between investors and renewed recession. Ergo, investors remain particularly keyed on central banker machinations.

Source: Natixis, HatTip: Business Insider

Note: US GDP, Source: Brad DeLong

1 Trillion USD Coin Madness 

Everyone of the current generation has heard scare stories of the dangers of unmitigated fiat money printing since John Law invented the Mississippi scheme in the early 1700s. Over the past 100 years, Germany of course has seen first hand the devastating effects of hyperinflation or quintuple-digit inflation caused by unmitigated debt monetization during the Weimar Republic of the 1920s. What is really scary is US economists recently (half) seriously debating the merits of a USD 1 trillion platinum coin. In 1923, a 1 trillion mark Zeigenhain German Gutschein coupon was actually issued.

As with their predecessor French elite in the early 1700s, governments who, like France after Louis XIV’s death in 1715 found their finances “in a state of utmost disorder”, have fallen for central banker fiat money schemes such as John Law’s bank of Law scheme (later erected into the Royal Bank of France) to inundate their countries and indeed the world with paper fiat money.
To hard money proponents and the average person on the street, nations financing their own debt by simply printing more fiat money is essentially a Ponzi Scheme, the natural progression ostensibly of which is to issue ever-increasing amounts of new money is issued to pay off prior debt holders, the eventual result being an eventual collapse of the currency that devalues all wealth based on that currency, including all financial asset wealth.

All That Increased “Cash” On the Sidelines is the Flip-Side of Government Debt

On the surface, the pain from the 2008 financial crisis and Great Recession was rather mild compared to the 1930s, at least for the top 10%. The following chart from McKinsey Global Institute shows global financial assets have increased some $16 trillion from the 2007 peak, and have rebounded some $37 trillion from the trough in 2008. A closer look however shows that the increase has come from public debt securities ($16 trillion) and non-secured loans ($8 trillion), while stock market capitalization is still $13 trillion below its 2007 peak. In other words, all that debt being issued by governments has become someone’s financial asset, and that the surge in financial deficits in the public sector is behind the financial surpluses (excess financial assets) in the private sector. 

Hat Tip: Business Insider

Then Why Isn’t Gold Already At $3,000/Ounce?

As everyone knows, the US has been the most chronic currency debaser over the past 40 years, with the trade-weighted USD depreciating well over 30% since 1970. Despite this, USD has remained the primary currency for global trade and central bank reserves. Since USD is essentially a key component of the global money supply, any attempt by the Fed merely to reign in the growth of greenbacks negatively affects the global economy. In other words, if the Fed were to adopt a real “beggar thy neighbor” currency policy, it would be to reign in what hard money proponents consider rampant debt monetization. 

As the global financial meltdown morphed into a Eurozone meltdown, the US Fed was joined by the ECB, the BoE and now the BoJ in the race to debase, not as a policy per se, but as the result of desperate measures to revive their economies. Seeing nothing but endless QE on the horizon, hedge funds and large institutions were convinced that all this fiat money printing would push gold to $3,000 or even $5,000 per ounce, and gold for a period went almost parabolic.

Yet the smart money (like George Soros and Louis Moore) is now dumping its gold holdings and Bloomberg is saying that hedge funds have cut their bets on gold by 56% from highs in October as gold prices consolidate, ostensibly on increased confidence in the economic recovery. Technically, gold could drop below $1,600 as it has broken below key medium-term support levels, despite continued buying by the world’s central banks, ostensibly to keep something that is not rapidly debasing in their reserves.

Thus the rapid appreciation (i.e., parabolic move) in gold over the past five years vs the major currencies seems to be behind us, Given the proclivity of  central banks to flood the markets with newly printed script at the first signs of economic weakness. it is still very much in doubt that the secular bull market in gold versus all major fiat currencies since the early 70s is over. However, a break below 1,600 could signal a medium-term correction to as low as 1,100, especially if central banks begin backing off the QE accelerator and real bond yields began to back up.

It would probably take a serious setback in what progress has been made in the Eurozone debt crisis, or as some suggest, a crisis in Japan’s debt problems, to set gold surging again.

Source: Galmarley.com

MMT Theorists: Simply Printing Money Does Not Lead to Hyperinflation

As for unmitigated mone printing causing hyperinflation and therefore a melt-up in gold prices, James Montier and MMT’ers (modern monetary theorists) insist hyperinflation is“not just a monetary phenomenon, as money supply is endogenous (and hence that interest rates are exogenous), and that budget deficits are often caused by hyperinflations rather than being the source of hyperinflations. This is because money (credit) is created almost entirely by private sector banks, not central banks.

As a result, the government’s loss or even reduction in the power to tax the output base is the real foundation for many hyperinflations. Thus in the case of an extremely advanced nation (such as Japan) with a powerful productive base and a sovereign that can tax that output, the odds of a hyperinflation (ostensibly from a currency collapse) are extremely low, barring the presence of such factors as a) large supply shocks (like during wars), b) big debts denominated in foreign currencies, or c) runaway cost of living, wage price inflation. Montier’s conclusion is that those forecasting hyperinflation/collapse from aggressive central bank money printing in the US, the UK and Japan are suffering from hyperinflation hysteria.

Source: Wall Street Journal

Indeed, the movement in US 10yr bond yields suggests ongoing deflation, not inflation, with growth expectations incorporated in these yields having yet to recover from the 2010 and 2011 “growth scares”, as long-bond yields are still lower than they were even one year ago. The need for central banks to introduce successive QE stimulus strongly suggests the developed economies remain in a classic liquidity trap.

The Next Trigger for a Stock Market Correction

Given the above, the BoA Merrill Lynch and other surveys suggest that investors have for the time being over-done their optimism, with the February ML survey showing four consecutive months of rising sentiment about the global economy. These investors continue to perceive value in equities despite the strong rally since June of last year, as most remain convinced that bonds are due for a tumble, with 82% saying bonds are overvalued. Other market sentiment indicators also point to short-medium-term over-enthusiasm for equities.

The VIX has plunged from the last growth share, which admittedly was overdone in the VIX as the selloff was not as severe as the VIX’s reaction. While the balance of market commentators (i.e., investors, traders interviewed by the financial press) now say stocks are “over-done” for the time being, but with the same breath say they want to jump in again with any sign of weakness. What this means of course that stock prices will not correct as much as many who have missed most of the latest up-leg would like to see.

Source: Yahoo.com

Investors were also non-plussed by the latest round of disappointing economic news, partially because these are backward looking indicators, but also because anyone who does not understand that the price of every stock and every bond is being artificially altered by the fact that interest rates are being heavily manipulated by major central bank QE consistently has underestimated the staying power of this market recovery.

BoJ Will Have to Continue Battling Weak Euro Growth, Continued Fed QE to Keep JPY Weakening

Hedge funds have piled into the short yen trade convinced that JPY may well have crossed the rubicon. But hedge funds have already made a ton of money on the short JPY trade, with George Soros alone reportedly making a cool USD 1 billion. The plunge in JPY has also recently slowed by more dovish Japanese comments ahead of the G-20 meeting, which are of course politically motivated to ameleorate criticism at the conference. G-7 officials have muddied the “verbal intervention” waters by issuing a currency statement, “clarifing it” it and then criticizing the clarification. Japan’s government (and JPY bears) were relieved when the Group of 20 finance ministers and central bank governors avoided specifically going after Japan’s reflation efforts as currency manipulation. Instead, the pledged “to monitor negative currency spillovers to other countries caused by monetary policies implemented for domestic purposes, and to refrain from competitive devaluation.” Meanwhile, the G-20 also put off plans for new austerity-inducing debt-cutting goals.

As seen below, the Bank of Japan’s asset purchase program was already on track to purchase a cool JPY101.1 trillion (over 20% GDP), but investors/traders were largely ignoring this until new PM Abe began talking about even more aggressive BoJ action. After some uncertainty about whether the G20 would take Japan to task for the rapid JPY depreciation since late October 2012, investors/speculators took the mild  G20 statement as tacit approval for further weakening of JPY, and giving encouragement to those predicting an eventual fall in JPY/USD to 200~300/USD. But these bears are basically talking their book. Ex-Soros Advisor Fujimaki (who says JPY400/USD is possible), makes his living advising Japanese clients to move their money offshore. BNP Paribas economist Ryutaro Kono, who sees a Japan fiscal crisis in 2015, was passed up for consideration for a BoJ post.

Source: Morgan Stanley

Source: XE.com

Speculative Short Positions Already Beginning to Unwind

The CFTC net open short position of non-commercial traders already peaked on 24 November 2012 after reversing sharply from a net long position peak on 21 August. Given the massive gains, traders are now taking profits, with the net short position now down some 20%, and the hot money is now looking for an excuse to lock in gains. Consequently, we view it unlikely that short traders can repeat these gains over the next couple of months. Indeed, the true test of weak JPY sustainability will be how JPY/USD trends as these short positions are cleared, as the shelf life of such overhangs of long-short positions have historically lasted only about six months.

Source: Oanda

What investors/speculators can expect is, 1) more currency volatility, 2) more interest rate convergence as central banks succumb to the Fed’s “whatever it takes” approach, which implies continued downward, not upward pressure on rates. As a result, the so-called “great rotation” could be much more prolonged than those recommending you dump all your bonds would have you believe. Technically, the JPY sell-off has breached its first target (the 92 handle), with the next target just under 95, and currency markets should remain extremely sensitive to US, Japan and Eurozone comments about JPY or factors that would affect central bank stance, interest rates, etc.

Bond Yields at Some Point Will Have to Get in Sync with Currency Market

The JPY selloff to date has come mainly from the concept, not the fact. If the BoJ fails to deliver what is already discounted in JPY/USD price, there is room for a significant setback. Even investment banks like HSBC argue the currency market is “attaching a probability to excess success”.

While strong “behavioral bias” from over a decade of falling JGB yields may have domestic investors still (undeservedly) tilted strongly to JGBs over equities, the fact is that JGB yields are not signing off the same song sheet as JPY/USD, and, we believe, not merely because of the prospect of aggressive BoJ JGB purchases. Indeed, the latest drop in JGB yields could be more attributable to the disappointing third quarter of declines in Japan’s GDP. We are in complete agreement with JP Morgan’s Kanno that a weak JPY and more aggressive BoJ won’t be enough to provide Japan’s economy with enough velocity to escape from its decades long slump without some ‘ole Junichiro Koizumi-style structural reforms. Thus domestic investors will have to be shown that Abenomics is for real, that the new BoJ policy board is completely on board with Abenomics, and that Japan’s economy is really pulling up before they really commit, despite the GPIF now beginning to consider the price risk in their extensive JGB portfolio from Abenomics.

Hat Tip: FT Alphaville

Japan Crisis Begins with a Collapse in JPY?

While most mainstream strategists and economists that follow Japan closely continue to downplay Kyle Bass’s widow-maker trade, as previously outlined, the scenario does have its fans, especially among the fast money crowd. Last October, Atlantic magazine called the Japan debt problem “The Next Panic”, suggesting Japan could be the next Black Swan event that really derails the central bank money printing-driven recovery. As Mark Twain said, “it ain’t what you don’t know that gets you into trouble, its what you know for sure that just ain’t so”.  “Everyone” overseas is convinced the Japan debt situation is a bug in search of a windshield,  and that the crisis in Japan will most likely come from a collapse in confidence in JPY.

However, Japan does not fit the pattern of countries that have had fiscal/currency crises, a) because the vast bulk of the debt is owed to its own people and b) Japan (still?) remains the largest net creditor nation. Japan’s rapidly growing elderly hold the bulk of their savings in cash and bank deposits. The banks and financial institutions in turn hold the bulk of government debt, with the Bank of Japan becoming an increasingly large factor in JGB demand. If Japan is going to default, it will more likely “soft” default against its own citizens in a form of financial repression. Japan’s savers could also effectively lose their savings through high inflation,but as James Montier has pointed out, central bank money printing alone is unlikely to cause this.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Is Breakdown in Gold the Canary in the Bond Bull Market Coal Mine?

• Investor, policy-maker attention is shifting from the global financial crisis to the bubble in credit markets.
• Surprisingly strong U.S. job growth could trigger an unexpected reversal in the Fed’s self-professed “endless” QE, triggering a 1994-like bond market debacle. Inside the Fed, the debate is apparently shifting from whether the Fed should do more to stimulate the economy to when it should start doing less. The last couple of times this happened (post 2008), they were forced by a falling stock market to do more. 
• While Wall Street “pros” have long warned about the risks of the bond market bubble, what they don’t mention is that stock prices and even gold would also get whacked in any bond market debacle, albeit to a less painful extent. 
• During the 1994 U.S. bond market debacle, JPY actually surged to a new historical high versus USD as Japan’s GDp turned sharply negative from the Kobe earthquake, and equity prices fell as the BoJ scrambled to slash interest rates, and Japan long-term real interest rates fell below U.S. rates. This is counterintuitive to what a positive (i.e., rising economic expectations) rise in US bond yields usually does to the Nikkei 225, i.e., the Nikkei historically has risen and JPY has weakened.

When Will the Great Bond Bubble Burst? 

The annual Davos gathering of movers and shakers in global politics and the world economy emerged from their meetings with an upbeat message: The Global Financial Crisis is Over; their new worry is a bubble in the credit markets. Increasingly, the blogosphere is questioning whether this signals the end of the great bull market in bonds. Bond traders and strategists have been warning the end of the secular bond bubble is inevitable for some time now, saying that the bond market is the worst investment one could possibly make. even as BoA Merril Lynch data were showing investors have poured USD800 billion into bond funds and redeemed USD600 billion from long- only equity funds. 

Could 2013 be the year? Will 2013 be, as feared, be a repeat of the 1994 bond debacle? We believe the key is, “when will the Fed (central banks) be confident enough to abandon quantitative easing and/or start tightening monetary policy?” 

To many, the “worst is over” does not mean clear skies and fair sailing. Christine Lagarde, managing director of the International Monetary Fund, cautioned that the recovery is still “fragile and timid”. Bond bears have consistently under-estimated the scope of the post-2008 malaise. As a result, bonds continue to outperform stocks, and could continue to do so if “balance sheet recession” Richard Koo is right, as the global balance sheet recession lingers for decades, as it did in Japan. Koo insists that, “inasmuch as this act of reducing financial liabilities in spite of zero interest rates runs counter to the principle of maximizing profits, it suggests that US households continue to undertake balance sheet adjustments.” The U.S. household sector has shifted to net negative savings, which has only been observed twice– following the collapse of the internet bubble in 2000, and after the collapse of Lehman Brothers in 2008. 

Unprecedented Policy Intervention Has Kept Financial Markets Afloat… 

There is plenty of evidence in the financial markets that central bank balance sheet expansion/liquidity provision/money printing have played a key role in buoying financial markets despite deep pessimism by investors. More telling is the rise each new infusion of liquidity brings is the fairly nasty decline seen when a previous program cycle winds down—in both the markets and the economy, as the fundamental drivers driver became policy intervention. With both the corporate and household sectors refusing to borrow, fiscal and monetary stimulus were essentially the only factors standing between the US economy and financial markets from falling into a deflationary spiral. 

But investors are beginning to sense a recovery beyond a short-term reaction to policy stimulus. Surveys indicate a growing confidence in the U.S. economy and ebbing concerns about Europe, with America seen as being its best shape in two years despite the circus surrounding the U.S. budget ceiling, and the improvement in the U.S. is having a positive effect throughout the world. Both stock market and economic bears are beginning to throw in the towel. 53% of investors polled by Bloomberg now expect stocks to be the outperformers in 2013: 

…But 2013 Could be a Year of Transition 

But 2013, as Ray Dalio suspects, could be a transition year, where large amounts of cash moves to stock and all sorts of stuff – goods, services, and financial assets, with people spending more with the cash, as economies begin to “normalize”. The European economy will still be terrible but gradual restructuring continues, and more confident investors in the U.S. will move out on the risk spectrum, while Japan could be awash with liquidity as Abenomics kicks in. A Bloomberg survey shows international investors are already the most bullish on stocks in at least 3 1/2 years, with close to two- thirds planning to raise their holdings of equities during the next six months. 

For bond investors, this transition could be very tricky, as talk of “rate normalzation” could be downright bad news. As pointed out by many strategists, the big risk of a rotation out of bonds into stocks in 2013 could be a 1994-like bond debacle. What they don’t tell you is that any big selloff in bonds will also drag stock prices down with it. 

The 1994 Bond Market Debacle Also Meant Lower Stock Prices 

By Q1 1994, economic growth began to accelerate as the U.S. economy emerged from a big recession after the S&L crisis in the late 1980s. Treasury yields had risen slightly from their 1993 lows as the growth outlook improved – though no other signs of inflation had yet emerged; wages were going nowhere, and companies dared not raise prices. Within seven short months, 1994 became the year of the worst bond market loss in history. Alan Greenspan and the Fed surprised markets by beginning to tighten monetary policy in early February, and Treasuries plunged as interest rates screamed higher throughout the year, inflicting heavy damage on financial companies, hedge funds, and bond mutual funds. With long-term rates rising in every major country, the worldwide decline in bond values was on the order of $1.5 trillion, as US 10yr treasury yields that had plunged from 9.0% to near 5.0% (400 bps) sharply reversed and surged nearly 300 bps in about 12 months. 

The S&P 500 also lost nearly 10% that year even though there was an interim rally of about 10% between April and September. In addition, gold prices also ended the year lower, although these losses were mild compared to the debacle in the bond market. 

Source: Federal Reserve FRED

Is Gold the Canary in the Bond Bull Market Coal Mine? 

Consequently, investors are likely to be ultra-sensitive to any indications by the Fed or other central banks in 2013 that they are becoming confident enough in economic conditions to a) allow QE programs to end and while currently inconceivable, b) begin tightening monetary conditions. Since the Fed also has a mandate to help ensure employment, if the global economy and corporate confidence rises enough to cause an upward surprise to US payroll numbers, say numbers in excess of 300K, this could also trigger a 1994-style “bond shock”. 

In this regard, one canary in the secular bull market in bonds coal mine could be the weakness in gold, which has historically tracked real interest rates. While real interest rates have not exactly soared, gold is acting like it is already anticipating higher real interest rates. Another canary is the high and resilient negative relationship between USD and nominal gold returns, where gold wanes on a strengthening USD. If USD begins strengthening on improved economic confidence despite Fed promises of “unlimited” QE, this sets up the bond market for a fall.

Fed’s Balance Sheet Would Also Get Crushed

A corollary to the bond market selloff scenario is that swollen central bank balance sheets would get crushed along with bond-heavy financial institution portfolios. The Fed’s balance sheet would get crushed (on a mark-to-market basis) on its USD3 trillion horde of government bonds. The Fed’s current unrealized gains of some USD200 billion would plummet to an unrealized loss of USD300 billion. The Fed’s contributions to the Treasury, which have cut some 10% off the annual deficit over the past few years,  The Fed then has annual losse, and a big hole in its assets, meaning 1) annual remittances to Treasury would fall to zero, adding to the deficit, but the magnitude of the change (-$80billion) ostensibly would not be that big an issue. An accounting “asset” would be created equal to the annual loss, with being in the form of a future claim on remittances to Treasury, i.e., an accounting gimmick.

How Would a U.S. Bond Debacle Hit JPY?

As US treasuries were crashing in 1994, JPY/USD surged from 124.99 to 83.69 before ending the year at JPY100.18, but eventually appreciated to a new high of JPY76/USD in 1995. But the economic environment for Japan in 1994-1995 was more like 2011. Japan’s GDP growth turned sharply negative in 1994 with the Kobeearthquake and falling stock prices. The BoJ was slashing interest rates, and Japan long-term real rates fell below those of the U.S.—similar to what was seen in 2011.

This runs counterintuitive to the long-term historical relationship between Nikkei 225 and long-term US treasury yields, which have a significantly high correlation. The weakness in JPY would also ostensibly be acclerated by an expanding spread between Japan and U.S. 2-year bond yields. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com