This week featured monetary policy decisions from four major central banks and two important labor reports. We also got a speech from John C. Williams, President and CEO of the Federal Reserve Bank of San Francisco that triggered worries about an early end to Fed easing.
On Wednesday, April 3rd, the S&P 500 (SPY) dropped 1.1% from all-time highs as the market (at least partially?) reacted to this part of the speech from Williams:
I expect that continued asset purchases will be appropriate well into the second half of this year…assuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year.
The market seemed to convulse on the notion that the Fed could actually end asset purchases but seemed to ignore the conditional of a much improved labor market and improving economy. Moreover, Williams did not express certainty, he expressed hope. In fact, Williams went to great pains to remain consistent with standing policy and highlighted that the Federal Reserve will remain in a very accommodative stance for quite some time. Here are related quotes starting with words that Williams inserted directly around the ones that freaked out the market:
I see the benefits of our asset purchases continuing to outweigh the costs by a large margin… it will take more solid evidence to convince me that it's time to trim our asset purchases…
It's important to note that tapering our purchases and even ending the purchase program doesn't mean that we are removing all the monetary stimulus that comes from our longer-term securities holdings. Instead, even as we cut back our purchases, we're still adding monetary accommodation and exerting greater downward pressure on interest rates. Economic theory and real-world evidence indicate that it's not the pace at which we buy securities that matters for influencing financial conditions. Rather, it's the size and composition of the assets we hold on our balance sheet. So, even when we stop adding to our portfolio, it doesn't mean we're tightening policy.
Earlier in the speech, Williams made several references to anchor expectations on accommodative policy well into the future:
It's vital that we keep those extraordinary Fed measures in place for some time to make sure unemployment and inflation get back to healthy levels."
"Even with the unemployment rate continuing to come down, it will likely remain above "normal" levels for quite some time. My best estimate is that the longer-run "normal" rate of unemployment is around 5½ percent. I don't expect the actual unemployment rate to reach that level until 2016."
"we're still far from maximum employment. And inflation is below the level we believe consistent with our maximum employment and price stability objectives. In these circumstances, the appropriate direction of monetary policy is clear.
Lo and behold, two days later, a worse than expected employment report put another dent in the likelihood of ending these asset purchases according to Williams' hopes. The S&P 500 fell again although it bounced nicely off the day's lows.
The S&P 500's churn continues as it bounces nicely off the lower-BB
Even more telling may be the U.S. dollar index (UUP). The benefit from a new wave of yen (FXY) devaluation (covered later in this piece) melted quickly as the euro (FXE) rallied strongly in the face of more bold talk from Mario Draghi, the President of the European Central Bank (ECB). I do not think it is a coincidence that the dollar index failed to push through its "QE2 price." The QE2 price is the level of the dollar index right before QE2 was telegraphed to financial markets back in August, 2010. Thursday's trade brought the index right to the brink of that resistance for the first time since the summer of 2012 when markets finally bottomed out from the last bout of euro-panic.
After finally breaking away from its QE3 price, the dollar index ran into a brick wall at its QE2 price
QE3 could not contain the dollar, but QE2 continues to do so
I think the firmness of this resistance marks a shift for the U.S. dollar. It should now trend toward weakness, perhaps as low as the QE3 price. I have started scaling out my U.S. dollar longs, but each currency pair has its nuances. I will cover them by going through each of the major currencies I follow… starting with the currency where my opinion has taken the most dramatic shift: the Australian dollar (FXA).
I covered the latest decision on monetary policy several days ago (see "The Reserve Bank Of Australia Marginally Concedes To A Brighter Outlook"). At the time, I stubbornly decided to hold onto my short Aussie bias with my short AUD/USD position given my expectation that resistance at the long-standing downtrend line would hold. I was rewarded but in a very unexpected way.
As the yen weakened rapidly in the wake of the Bank of Japan's (BoJ) decision on monetary policy, the U.S. dollar initially benefited most. It seemed as though the choice currency for betting against the yen was the U.S. dollar as the dollar initially gained on the euro and the pound. After the Bank of England (BOE) and the ECB released their decisions on monetary policy, it was as though the sigh of relief that sent those currencies gaining against the dollar, completely forgot about the Australian dollar. While the Australian dollar gained 4.3% against the Japanese yen (AUD/JPY) in the wake of the BoJ decision, it still lagged the gains of other currencies, resulting in the Australian dollar lagging the U.S. dollar, the euro and the pound in related crosses. The charts below tell the story:
AUD/JPY crosses 100 for the first time since the month before Lehman Brothers collapsed
...but AUD/USD further retreated from resistance at the downtrend line
I think after the dust continues to settle, the Australian dollar will gain more favor. This momentum could pick up if Japanese investors and traders decide Australia is a good place to stash their rapidly evaporating currency. My expectation for U.S. dollar weakness and carry trade momentum suddenly have me favoring the Australian dollar again after nearly two years of bearishness. I have switched to long AUD/USD, will buy the next dip in AUD/JPY (hoping one comes!), and I am fading the bounces in EUR/AUD and GBP/AUD as relief rallies that will soon fade.
I had always figured I would not get bullish on the Australian dollar again until a major correction, but one has yet to arrive. For example, AUD/USD has held support around 0.95 or 0.96 since the end of 2010. If that level somehow breaks anytime soon, I will of course need to re-evaluate.
No superlative is enough for the rapid weakening in the Japanese yen in the wake of the BoJ move. When I wrote about how the Nikkei was finally selling off just on the heels of a 3-week strengthening of the yen, I claimed that it had opened a rare buying opportunity for iShares MSCI Japan Index (EWJ) and a good spot to open fresh shorts on the yen. However, I did not anticipate this instant surge to fresh 2+ year highs for EWJ.
EWJ gaps up to fresh highs in the wake of the BoJ
2013's rapid gains only take EWJ back to where it was the week before disaster struck the country in 2011
Plenty has already been written about the prospects for the yen, the Japanese economy, and monetary policy, but I want to highlight a few points that particularly caught my interest.
First, there is Seeking Alpha Contributor Axel Merk writing before the BoJ announcement: "Japan: Monetary Madness In Times Of Unsustainable Deficits?" He makes some excellent points:
The Japanese government will not be able to finance its debts if government bonds actually reflect the 2% inflation premium of a successful inflation-targeting campaign.
Monetizing the debt by the Bank of Japan will set up a negative feedback loop that will further weaken the yen.
The BoJ's inflation target uses a CPI that includes energy costs. A weaker yen will drive up the cost of energy imports. Thus, the BoJ must certainly target a weaker yen to achieve its inflation target.
Merk further seems to imply that a world that lacks the "safety" of the Japanese yen will be one much more dangerous for investing. I am not so sure as investors will surely alternatively rotate through the usual suspects. This will certainly increase volatility in currency markets and create a lot of interesting/attractive trading opportunities. I think in particular the Australian dollar will benefit even from safety trades as it becomes clearer the RBA is not likely to reduce rates much further, if at all. Regardless, the Aussie will maintain a substantial rate differential for some time to come over other major currencies. (Perhaps an imminent danger is a flood of borrowed yen causing asset bubbles to sprout around the globe).
George Soros supposedly made another cool billion shorting the yen which he of course says the BoJ is happy for him to do. In an interview on CNBC International, he maintains that an "avalanche of weakness" is likely coming as Japanese people rush to get out of their weakening currency and into investments abroad. He claims that until now no one really believed that Governor Haruhiko Kuroda would have the courage to do what he has done. If he is correct, the yen's fresh weakness is truly just getting started.
Finally, hedge fund manager Kyle Bass has long been bearish the yen and Japan in general. I have covered a few of his interviews in previous posts. Of course, he returned to CNBC to extend his warnings. Bass implies that the plan to double the monetary base in just two years is an extreme experiment born out of desperation. Government debt is already 20x tax revenues so there is no choice but to monetize the debt. To that end, the BoJ abandoned the "Bank Note Rule" which prevented the BoJ from monetizing more debt. Bass continues to call Japan effectively insolvent, and I am taking him to heart when he warns that the Japanese stock market is not attractive. He calls Japanese industry "hollowed out." I have put a short leash on my EWJ shares and will likely wrap it up soon (I will post the trade real-time on my Dr. Duru twitter account). Finally, Bass says to look out for an announcement from the BoJ that it will also buy more foreign bonds which would then ignite an implicit trade war, primarily with South Korea. Japan has lost much of its trade competitiveness to South Korea.
Bass's target for USD/JPY is 118 to 120. Bass thinks it could go much higher if the BoJ loses control of the currency. The potential for an uncontrolled devaluation is a common theme I continue to see in commentary on the Japanese yen.
Here are some charts to show where this next phase of weakness has placed the yen against the U.S. dollar and even the British pound. You should see the clear markings of a new breakout.
No rest for the weary - the yen looks ready to get a lot weaker on a breakout of USD/JPY to 2009 levels
Playing the British pound against the yen may be even more attractive given the amount of upside to be gained from pre-crisis levels
I mention the British pound (FXB) as potentially an even better play than the U.S. dollar because it seems to have bottomed for now.
The Bank of England delivered no surprises in keeping rates and QE steady. However, with economic conditions weakening, the lack of action seems to imply that stubbornly elevated inflation levels are causing hesitation. All eyes will turn to the April 17th release of the minutes from the meeting for more insight into how the BoE is currently thinking. The reaction to those minutes should solidify whether I remain bullish the pound or rapid retreat back to my standard pound bearishness.
In the meantime, GBP/USD has seemingly bottomed as the currency pair has recovered from a breakdown to levels last seen in the summer of 2010. GBP/USD has traded above its 50DMA after failing at this resistance level earlier in the week. For now, I set up a fade in anticipation of GBP/USD pulling back and testing the 50DMA as support before resuming its rise. I will exit if instead GBP/USD shows immediate and convincing follow-through. Regardless, I am now reluctantly dropping my overall bearishness on the British pound in favor of positive short-term momentum from this apparent bottoming. Assuming the U.S. dollar continues to weaken, I prefer to play the action with Australian dollars, but I suspect the British pound may provide even better short-term setups from time-to-time. As mentioned above, I think GBP/JPY may offer considerably more upside than USD/JPY; it could be a better partner with a long AUD/JPY position.
GBP/USD appears to have bottomed for now
The ECB also left rates unchanged and did not announce any changes in monetary policy. My favorite quote from Draghi came during the press conference Q&A (emphasis mine):
"You are asking questions that are so hypothetical that I do not have an answer to them. However, I may actually have a partial answer. These questions are formulated by people who vastly underestimate what the euro means for the Europeans and for the euro area. They vastly underestimate the amount of political capital that has been invested in the euro. And so, they keep on asking questions like "if the euro breaks down" and "if a country leaves the euro area tomorrow". The euro is not like a sliding door, it is a very important thing; it is a project in the European Union. So, that is why you will have a very hard time asking people like me "what would happen if?" There is no plan B.
In addition, I think the ECB has shown its determination to fight any redenomination risk, and OMTs, with their precise rules, are there for this purpose."
Soon after that, the Q&A session ended and the euro was on its way to rallying against the U.S. dollar. I show a 30-minute chart below just to highlight the correlation:
The euro rallies against the U.S. dollar first on ECB and then U.S. employment news
This rally put the euro at a critical technical juncture against the U.S. dollar. It faded a bit to close the week just under its 200-day moving average (DMA). The 50DMA is rapidly declining. It looks like tough resistance to overcome but weakness in the dollar index essentially hinges on the euro overcoming this resistance. I will be watching closely.
The euro is facing some stiff overhead resistance
One factor working against the euro is the creeping recovery of the Swiss franc (FXF) from weakness earlier in the year. It is possible the franc could become somewhat attractive again as a "safety" currency with the yen successfully destroying that mantle for itself. However, the imposed floor of $1.20 looms. The last two days do not show the deep plunge I might expect if serious money was fleeing the yen and going into the franc. I am watching it though as I never expect the euro to strengthen against the U.S. dollar while the Swiss franc is also strengthening. Indeed, the euro's two-month slide against the U.S. dollar was accompanied by overall EUR/CHF strength. EUR/CHF tends to serve as a telling referendum on euro sentiment. In the meantime, I have started scaling into EUR/CHF as it is "close enough" to my $1.21 buying target.
The euro has yet to regain its momentum against the Swiss franc that is achieved earlier in 2013
Source of charts: FreeStockCharts.com
Be careful out there!
Additional disclosure: Long SSO through call options. In forex, short GBP/USD, net long Australian dollar, long EUR/CHF, long USD/JPY