With all the focus on will the Federal Reserve signal stronger tapering measures this week, I thought it is a good time to review how the market has arrived at this fixation on Fed policy as we approach mid-year 2013. In doing the review, it became evident that the investment world, at least as it relates to the inter-action between the U.S. and Japan, is acting differently than it has over the past 20-30 years. Since the beginning of the year investors have witnessed some significant policy moves on the fiscal and monetary front in both the U.S. and Japan.
At the beginning of the year, Ben Bernanke's Federal Reserve began implementation of its $85B a month Treasury buying spree that is forecast to last the entire year of 2013. In addition to the monetary policy, the U.S. government has taken steps to tighten its budget through tax increases and budget cuts. The net impact of the fiscal changes has been to slow the need for the level of new U.S. Treasury issuance over the first half of 2013. The combination of lack of supply of U.S. Treasuries for investment and the increase in monetary supply through bond purchases by the Federal Reserve has created a scenario in the U.S. market from January to May in which too much money has been chasing too few investments, and stocks have increased dramatically over the first half of the year. From a chart standpoint the rise is exponential.
But there are players other than the Fed in the unfolding saga of central bank driven economic policies around the world. And the most active player from a policy change standpoint in the first half of this year has been the Bank of Japan's monetary policy in conjunction with Shinzo Abe's announced fiscal stimulus package. The Bank of Japan announced on April 4, 2013, that it would target an increase in its monetary base of $60-70T yen a year and do whatever it takes to hit an inflation target of 2% a year.
The combined moves of the BOJ and the U.S. Federal Reserve have had a jolting impact on the value of the two country's stock markets.
Both the S&P500 and Nikkei are up significantly in the first half of the year, with the Nikkei (JP:NIK) (DXJ)(EWJ) suffering a major 20% correction after its rapid ascent recently. Likewise there has been increasing volatility in the value of the USD relative to the yen. It seems rational that policy moves by central banks that remove certain stores of value from the market such as government bonds will cause cash assets to seek other markets for investment. So, a front-running trade to bid up the stock markets in the U.S. and Japan in advance of actual policy implementation seems a natural market action. But the real anomaly in the recent trading activity has been in the about face move in the USDJPY from weakening to sudden strengthening. (FXY) (JYN)
It is the divergence of the yen at this time, June 2013, that needs better understanding. From a policy standpoint, the Japanese government is on paper being far more aggressive in relative terms than the U.S. with its monetary policy; and the program is projected to go beyond the timeframe that the Federal Reserve has currently projected. Although if you really review the history, the Fed is always undertaking some form of monetary operation. With the Federal Reserve starting to signal that it will scale back monetary operations, the expected tightening, when combined with a tighter U.S. fiscal policy should have market expectations pushing the yen to an even weaker valuation. But the opposite, at least since mid-May, has been happening.
Is this a simple retracement of a market that has gotten ahead of itself? Or, is there something going on that is being driven by the dueling Central Bank policies that is leading to a different outcome than what front-running market players such as hedge funds have been anticipating? The data that I have been watching for the first half of the year may surprise you.
Important to Examine the Data - Not Assume
The paradigm that investors have used for years in the inter-relationship of the U.S. and Japanese markets is that excess capital in Japan will seek other capital markets for investment in order to maintain a relatively weak yen in support of Japan's export industries. As the discussion of monetary and fiscal policy changes in Japan was under way late last year, not surprisingly stock markets began to bid up prices in anticipation of the expected outcome. In the case of Japan's fiscal and monetary actions, the expectation was for a weakening of the yen caused by an outflow of capital generated by a much looser monetary policy.
Based on the expected market relationships, the S&P500 (SPY) and the USDJPY have traded with an almost 1:1 correlation from February 1, 2013, until June 7, 2013, (actually the relationship is strong all the way back to November 15, 2012). During the week after June 7, the correlation finally broke down. It remains to be seen whether it is a temporary respite, or a signal for future concern.
Why the Pressure is on for the YEN to Strengthen
The breakdown of the yen weakening relative to the USD, and thus the breakage in the correlation to the U.S. stock market may seem incidental to many. But strong correlations of a foreign currency to an exponential rise in the S&P500 since the first of 2013, after already significant gains from the lows of 2009, is a sign that something is changing. In other words, it is time to pay attention. Unfortunately, when things begin to change after large advances in asset prices, it usually means there is a busted trade and the risk of cascading losses start to build up in the markets. I raise this concern because since the first of this year investors have witnessed a growing number of market unwinds - gold (GLD), emerging markets (IEMG), U.S. Treasury markets (TLT) (TLH) and the Nikkei. And now we see a changing dynamic in the yen relative to the dollar, at a time when many are expecting further yen weakening.
To assess the risk and understand why this is happening, I have done an in-depth review of the capital flows since January 2012 into and out of Japan that influence the price of the JPY relative to the USD.
The following series of charts examine the investment capital flows from sales and purchases of investments by various groups that would influence the relative strength or weakness of the yen over the last year (yen has been converted to USD based on the prevailing average monthly exchange rate in all data obtained from the Japan Ministry of Finance).
In the chart above, you can see that during the majority of 2012 as the yen was strong but began to weaken, capital flowed out of Japan. The securities most often purchased by Japanese residents were bonds. In the year of 2012, Japanese residents bought over $200B in foreign bonds. The data does not reflect what percentage was U.S. government or company bonds, but it was likely high. On the other hand, Japanese residents were net sellers of foreign stocks during 2012 by $25B. The overall outflow of capital from Japan in 2012 was supportive of weakening the yen. Against the USD, this is what happened beginning slowly mid-year, and accelerating into year end.
The interesting information in the data shows up in 2013. From the beginning of the year onward, Japanese residents have brought investment capital back into Japan. The sale of foreign equities continued. But more important information in the data is that the Japanese resident investors began to sell foreign bond investments. This seems like a rational investment move. The yen has depreciated considerably, and to the extent the bonds were U.S. based, interest rates are at all-time lows. It must look like a perfect time to sell high.
Another major influencing factor on the value of the yen is the recent run-up in the Nikkei and the corresponding inflow of capital into Japanese equities. The chart below shows the level of capital that has flowed into Japan since the beginning of 2012:
The inflow of capital throughout the majority of months since 2012 has tended to put pressure on the Japanese yen to rise. The data show that the majority of the capital has flowed into equities and out of Japanese bonds since October of 2012. Prior to October 2012, the investment flow was primarily into Japanese bonds. The large outflow months in October 2012, December 2012 and March 2013 were all major withdraws of funds from foreigners from Money Market Accounts - money on the sidelines that went somewhere else.
The third major area examined to get an understanding of what is influencing the value of the yen, particularly as it directly relates to the USD, is the changing level of investments in U.S. Treasury securities. The chart below shows Japan's net position changes in U.S. Treasuries by month from May 2012 through April 2013 (the latest month data is available):
The trend in this data is very interesting. The prime method over the years by Japan and other Asian countries to weaken their currency relative to the USD is to purchase U.S. Treasury securities. U.S. Treasuries and U.S. Government Mortgage backed securities have been a primary investment in the carry-trade diet for years. But look at the data - the BOJ has been a net seller of U.S. Treasuries since the end of 2012. Whether this is willingly, or a result of called issues, which have ended up on the Fed balance sheet, I do not know. But the trend is clear. This data again should be putting pressure on the yen to strengthen, not weaken.
Japan's Trade Balance Data
The last major influencing factor on the relative strength or weakness on the yen that I examined is the Balance of Payments data for Japan over the past year - specifically the current account surplus / (deficit) by month. These data are in the chart below.
It is not surprising that Japan, a major net exporter nation, has run a current account surplus a majority of the time over the past 12 months. Japan has an export-driven economy and the trade balance surplus is what would be expected. There is one point in the chart, which did peak my interest. At the end of 2012 and early 2013, Japan ran a current account deficit. This was the same time period that the yen actually did begin to weaken. However, as we progressed into the spring of 2013, the current account again showed its usual surpluses.
Summarizing the Japanese YEN Currency Relative Strength versus the USD
When all of the data are put together, the tendency of the yen to strengthen versus the USD after its run up over 100 USDJPY becomes clearer. The chart below shows all the sources of investment capital flows over the past year into and out of Japan, including Japan Resident Foreign Investments, Foreign Investor Purchases of Japanese Investments and BOJ net purchases / sales of U.S. Treasuries. The chart also shows the value of the USDJPY over the past year.
In Japan, the current account surplus must be accompanied by a net outflow of capital in order for the yen not to have a strong tendency to rise against the USD. Also from the data, it is important to remember that Japan ran a current account deficit from November - January in the chart timeframe above (these data are not in the investment capital flow data on the chart - it is additive). When all of the data are combined the weakening of the yen up to February of 2013 appears to have a good rational basis.
However, since February actual data and the directional move in the currency relative to the USD have been very much out of synch.
It is only speculation as to why this has happened. Obviously currency speculators and front-running carry-trade positions may be playing a role. There was a tremendous expectation that because of Abe Shinzo's announcement that the yen carry trade would once again become that status quo relationship between the U.S. and Japanese financial markets. Many investors may have raced out in front of this trade by indirectly borrowing in yen and buying the U.S. stock market. If this is the leveraged position of anyone's portfolio today, that person is really betting on "hope," and looking for a set of crutches from Ben Bernanke this week - because the data, which track real investment capital flows shows this position is busted. It actually looks more likely that the yen may return to the level it traded last summer unless Ben Bernanke allows U.S. interest rates to rise dramatically - much more than they already have.
Does Ben Bernanke have Carry Trade Crutches?
How can Ben Bernanke prop up investors caught in a leveraged yen-financed U.S. stock market position? It is not clear at this point he can.
On Wednesday, if the Fed Chairman announces a much slower pace of tapering in QE, he really is just promising to back-fill the increasing outflow of foreign investment in U.S. Treasury securities - some of which is Japanese based. Suppressing of U.S. interest rates at this point by continuing to make high levels of Treasury purchases as capital flows out of the U.S. will only work to strengthen the yen - and weaken the USD.
If the Fed announces that it will taper much quicker, this could serve as an eventual means to attract a stronger flow of funds back into the U.S. to finance the U.S. government deficit as well as the ongoing current account deficit. However, stronger tapering talk near term is a big negative for the stock market.
The Real Danger to the S&P500
The information about what is happening from a Japanese market perspective is informative, if not outright concerning for the S&P500 investors taking new positions now. What is propping up the U.S. market right now is fear - fear that U.S. interest rates will rise. Japanese investors are exiting the bond markets worldwide even as their domestic policy supplies an even greater level of financial liquidity. Additionally, the Bank of Japan, and other worldwide central banks are lowering reserve levels of U.S. Treasury securities. Some of this activity may be a direct result of Jack Lew's public statements on May 10, that Asian countries that enter the U.S. Treasury market to weaken their currency with purported "domestic stimulus expenditures" will be heavily scrutinized.
Whatever the rational, the data reflect a cascade of pressure on the U.S. Treasury market to unwind. In reality, what was once a QE program to add domestic market liquidity to encourage investment and somehow promote job growth is turning into a revolving facility to off-set foreign sales of Treasury bonds.
The Fed's $85B a month budget may not be enough to cover the total outflow, which might be encountered if selling pressure continues. I track the foreign purchases of U.S. Treasuries, which is currently at a near all-time high of 47.5% on the Financial Calculus website. The April release of the foreign purchases was interesting. It shows a .8% down-tick in relative foreign positions from March to April - with many countries in Europe as well as Japan being the sellers. I expect a higher downtick in May.
The outflow of funds in this fashion from foreign investment usually does not end well for the U.S. stock market if it continues for any length of time. In the time frames over the past 50 years where there has been a net outflow of U.S. Treasury bond investments by foreigners, the most significant downward change happened in late 1999 into the year 2000. This move preceded a sharp move downward in the stock market. A similar movement of foreign investment happened in 1973-74. With the precariously high level of foreign investment today, this issue is the number one specter, in my opinion that is hanging over the market.
Investing Strategy Today
My advice is that the Japanese resident investors seem to be taking the most rational approach to investing at this point. Reduce high-duration bond and risky equity positions, re-trench and wait for a better entry point. This is because the reason that U.S. rates are rising is not primarily economic activity, as many would like to believe, it is because of an exodus of capital - which the strengthening of the yen reflects. Hiding out in the stock market for protection in this scenario is not a very good idea. Taking new positions right now is probably bailing out someone who is lucky to be getting out of a busted carry trade.