Concerns about the weakening U.S. and global economies and the Bank of Japan's, or BOJ's, negative interest rate policy, as well as a Brexit vote have put buying pressures on the Japanese yen and gold as safe-havens. Both the JPY/USD exchange rate and gold price, which show a positive correlation (+0.82) over a 100-day period, have been on the rise since December last year, despite weak gold demand in India and China. This trend could continue into the future as the Bank of Russia and the People's Bank of China are shifting away from the U.S. dollar to gold.
The recent move by the BOJ to refrain from expanding monetary stimulus sent the yen skyrocketing over 2% on Thursday, to around 103.50 yen to the U.S. dollar, a level has not seen since August 2014. While the BOJ decision came as no big surprise, bond traders bought 10-year U.S. Treasury Notes, pushing the yield on the benchmark 10-year note to its lowest level in nearly four years. The yield spread between the 10-year and 2-year U.S. Treasury Notes tumbled over 4%, to close at 0.87 percentage points on Thursday, a level not seen since late 2007.
In May, when the Japanese government was about to enter into an all-out global currency war, Finance Minister Taro Aso threatened to intervene in foreign exchange markets and said that the Japanese government would not tolerate a persistent "one-sided" rise in the yen. He warned that the government was "determined to stop it", according to the Australian Financial Review.
A yen intervention by the BOJ won't work when the USD/JPY exchange rate and the yield spread between the 10-year and 2-year U.S. Treasury Notes are directly correlated, as currency traders will sell the U.S. dollar and buy yen when the U.S. Treasury yield spread is narrowing. The last intervention by the BOJ was in August 2011 when the bank sold a record 4.5 trillion yen and bought U.S. dollars, causing the yen to tumble temporarily. But a week later, the currency was back above its levels before the intervention. At that time, the U.S. was in the middle of a debt-ceiling crisis, with a third-quarter 2011 GDP of 2.0% and unemployment rate of over 9%. The Fed funds rate was between 0% and 0.25%.
Faltering U.S. Economy and Narrowing Yield Spread
There are warning signs that the U.S. economy may not be as strong as Federal Reserve and U.S. Government officials have painted it to be, as job growth is decelerating while the core personal consumption expenditures, or PCE, index used by the Fed to measure the inflation, continues to run below the Fed's 2% inflation target.
According to the Department of Labor, U.S. nonfarm payrolls has declined steadily from 295,000 jobs added in October 2015 to 38,000 added in May 2016, while hourly wages inched up a mere 1.18% from $25.21 per hour to $25.59 per hour during the same period, due in part to a rise in minimum wages in some states and cities.
Core PCE, excluding food and energy, climbed from 109.86 in October 2015 to 110.87 in April 2016, an increase of just 0.92%. The core PCE price index for April came in at 1.6% on a year-on-year basis, unchanged from the previous month. In fact, the core PCE has been running in the 1.5% range since early 2013.
The recent Manufacturing Business Outlook Survey by the Federal Reserve Bank of Philadelphia, also known as the Philly Fed, showed the manufacturing index ticked higher in June, but the employment index, which remained negative for the sixth consecutive month, plunged from -3.3 in May to -10.9 in June.
Just two days after the Federal Reserve decided to leave the Fed Funds rate unchanged on concerns about slowing jobs growth, St. Louis Fed President Jim Bullard, a voting member of the FOMC, shocked the financial markets by saying that low growth and a very low Fed funds rate, of just 63 basis points, will likely remain in place through 2018. That is a major policy shift since Mr. Bullard told CNBC in late May that a U.S. Federal Reserve rate hike in June or July wasn't set in stone, but labor data suggested it was time to pull the trigger.
The yield spread between the 10-year and 2-year U.S. Treasury Notes, one of the economic indicators, has been on the decline since it peaked in December 2014 at 2.66 percentage points, two months after the FOMC decided to end the quantitative easing program. Soon after, Wall Street economists stepped up their speculations about the timing of the Fed's first rate hike and sent fear to bond market, which had already driven the 10-year and 2-year U.S. Treasury Notes yield spread lower.
Narrowing spreads may indicate worsening economic conditions in the future, resulting in a flattening yield curve. A very low or negative spread could signal an upcoming recession. Since 1960, each time that the yield spread went negative, a recession followed approximately 12 months later.
From a historical perspective of the Fed leading up to the last U.S. recession, from December 2007 through March 2009, the Fed began hiking the short-term rate from 1.0% to 1.25% in June 2004 as the yield spread between the 10-year and 2-year U.S. Treasury Notes stood at 1.9 percentage points. By the time the Fed raised the key rate by a quarter-percentage point to 5.25% for the last time in June 2006, the yield spread was already in negative territory.
Many Wall Street economists may not be aware that the S&P 500 Utilities sector is now trading near its all-time high, as money has rotated into safe-havens. The last time Utilities outperformed the broader market, a U.S. recession followed.
Yen and Gold Technical Levels
The USD/JPY has fallen about 7% since late May and bounced at the key trendline supports at 103.58 yen. If the currency pair continues to pull back, the next support level is 100.67 yen, or the 50% Fibonacci retracement level. In a note published in the Financial Times this week, Alan Ruskin, the New York-based Global Head of G10 FX Strategy at Deutsche Securities, said the BOJ would likely step in if the dollar "threatened or breached" the 100 yen level.
Here is Ruskin's take,
The BOJ would likely intervene 'under the cover' of the U.K. referendum vote, by making a strong case to the U.S. and G20, that i) Japan is being placed under unique duress from a dramatic tightening in financial conditions allied to the stronger yen; and, ii) that the exchange rate is reflective of volatile international events, and not domestic conditions.
Last month, the U.S. Treasury issued a stern warning against any action by the Japanese government to weaken its currency, as there should be no disorderly trading in the yen that would justify intervention. In April, the U.S. Treasury placed Japan, as well as China and Germany, on a new currency watchlist, warning that all three faced extra scrutiny and potential retaliation by Washington, as a result of concerns over growing imbalances in their trade relationship with the U.S.
The gold price bounced off its December low of $1,045.40 per ounce and broke out the bullish descending wedge chart pattern in February. Gold has now broken back into the ascending channel, and is bumping into the 38.2 Fibonacci retracement level at $1285.57. If the yen continues to gain strength, gold could follow and head to the $1,430 resistance level, followed by the 23.6 Fibonacci retracement level at $1,529.46. As a reminder, gold demand could drop further as the price goes up.
Concerns about the weakening U.S. economy has put buying pressures on the Japanese yen and gold as safe-havens. As a result, the yen has skyrocketed to a level not seen since 2014, the 10-year U.S. Treasury Notes yield is at its lowest level in nearly four years, and the yield spread between the 10-year and 2-year U.S. Treasury Notes, at 0.87 percentage points, is at its lowest since late 2007.
Japan's threats to intervene in foreign exchange markets to stop the rise in the yen won't work since the USD/JPY exchange rate and the yield spread between the 10-year and 2-year U.S. Treasury Notes are directly correlated. In a weak U.S. economic environment, currency traders will sell the U.S. dollar and buy yen when the yield spread is narrowing. The last time the BOJ tried to intervene in 2011, the yen tumbled only temporarily and was back to above its levels before the intervention in a week because the U.S. economy was weak.
The USD/JPY has fallen about 7% since late May and bounced at key trendline supports but if the currency pair continues to pull back, the next support level is 100 yen or the 50% Fibonacci retracement level. The gold price bounced off its December low and has now broken back into the ascending channel, and is bumping into $1285.57 or the 38.2 Fibonacci retracement level. If the yen continues to gain strength, gold could head to the $1,430 resistance level.
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