Japanese Yen And Gold Poised For A Rebound As U.S. Dollar Rally May Begin To Fizzle

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Summary

The financial markets continue to price in President-elect Trump’s large-scale fiscal stimulus to the U.S. economy, but the rally could soon fizzle.

FOMC participants incorporate assumption of more expansionary fiscal policy in their forecasts despite warning from the Fed’s Dudley of “considerable uncertainty”.

U.S. dollar is overvalued and Japanese yen is undervalued at these levels, according to analysts.

Japanese yen and gold price uptrend moves could be supported by weakening yen cross rates.

The U.S. Dollar index, or DXY, which is essentially the USD/EUR exchange rate, has rallied 8.25% from its November low of 95.905, following Trump's presidential victory, to a 14-year high at 103.82 last Tuesday. The financial markets continue to price in President-elect Trump's campaign promises for large-scale fiscal stimulus to the U.S. economy, which would drive inflation sharply higher and prompt the Federal Reserve to accelerate its interest rate increases. According to the Commodity Futures Trading Commission, or CFTC, there were 64,527 contracts of speculative long U.S. Dollar Index futures, compared to 10,232 short positions in the week of January 3.

U.S. Dollar Index Technical Chart

The minutes of the December Federal Open Market Committee, or FOMC, meeting released last week, revealed that almost all the FOMC participants "indicated that the upside risks to their forecasts for economic growth had increased as a result of prospects for more expansionary fiscal policies in coming years", while about half of the participants "incorporated an assumption of more expansionary fiscal policy in their forecasts".

President-elect Trump has outlined plans without any details for a trillion dollar investment in infrastructure over ten years, which offers $137 billion in federal tax credits to private investors who want to back transportation projects. He also has proposed several tax plans, which includes a business tax rate reduction from 35% to 15%, and the elimination of the corporate alternative minimum tax. One of the plans will also provide a deemed repatriation of corporate profits held offshore at a one-time tax rate of 10%.

President of the New York Federal Reserve Bank William Dudley warned in early December that there is "considerable uncertainty" about how fiscal policy will evolve under the Trump administration and the Republican Congress. "We don't know what the fiscal policy is, we don't know how big it is and we don't know when it is actually going to occur," he said.

U.S. 10-Year Treasury Notes

Trump's proposed policies have also fueled speculative trades in the bond market, sending the yield of the 10-year U.S. Treasury Note up 0.72 percentage point since the November election, to a 52-week high of 2.60% on December 16, while the yield spread between the 10-year and 2-year U.S. Treasury Notes has widened about 0.77 percentage point to 1.34% during the same period. The Japanese yen (NYSEARCA:FXY) and gold (NYSEARCA:GLD) sold off as the 10-year/2-Year yield spread widened, considering that the USD/JPY exchange rate and 10-year/2-Year yield spread have a positive correlation (+0.93) over a 100-day period. The correlation between the JPY/USD exchange rate and gold price is also positive (+0.97) over the same period.

USD/JPY vs 10Y/2Y Spread

JPY/USD VS Gold

From our viewpoint, the U.S. dollar rally, which began after the November U.S. elections, could soon fade after the DXY was rejected at the 103.50 resistance level, at which the U.S. dollar might be highly overvalued, according to UBS. The strong dollar may be unsustainable when the U.S. economy, which has grown at a compounded annual growth rate, or CAGR, of 2.1%, since the deep recession of 2009, is expected to grow at a pace of 2.1% in 2017, according to a median projection by the Federal Reserve at the December FOMC meeting. Traders could exit their speculative long DXY positions if the Trump administration's details and timelines for its big infrastructure and tax bills fail to meet expectations.

USD/JPY Exchange Rate

Gold Technicial Chart

In our view, the Japanese yen could gain upside momentum if the USD/JPY currency pair continues to pull back further from the 118.70 resistance level. The gold price should resume its uptrend along with the Japanese yen, after bouncing off the 10-year trendline support in mid-December.

Decelerating Total Nonfarm Payrolls and Job Openings Growth

The Federal Reserve's statutory objectives for monetary policy, established by the U.S. Congress in the Reform Act of 1977, can practically be summed up as follows: maximum employment, stable prices and moderate long-term interest rates, which may be achieved by targeting an inflation rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, or PCE.

Maximum employment is vaguely defined by the Fed but is benchmarked with the natural or normal unemployment rate, a combination of frictional and structural unemployment, to determine if the level is achieved. As of December 2016, the FOMC estimates the longer-run normal rate of unemployment to range from 4.5 to 5.0%, and have a median value of 4.7%.

Although the improvements in the labor market have pushed the unemployment rate down to 4.7%, which is "near what it was before the recession", according to Fed Chair Janet Yellen in her prepared remarks in mid-December at the University of Baltimore's commencement, total nonfarm payrolls grew just 1.58% year-on-year to an average of 145.13 million during the fourth-quarter 2016, the slowest growth since the first-quarter 2013.

U.S. Nonfarm Payrolls

Average hourly earnings in the fourth-quarter grew 2.73% year-on-year, to $25.94 per hour, the fastest growth since the third-quarter 2009, with a compounded annual growth rate, or CAGR, of about 2.12% from 2009 to 2016. Despite the tight labor market and minimum wage hikes in many states, growth in wages is still lagging compared with the 2.88% to 3.5% year-over-year rise during the 2007-2009 recession.

JOLTS

The Job Openings and Labor Turnover Survey, or JOLTS, data carefully watched by Ms. Yellen, reported monthly by the U.S. Department of Labor, also revealed that average job openings in the fourth-quarter 2016 was up 3.9% year-over-year to a seasonally adjusted 5.53 million. Despite the fact that total nonfarm payrolls growth is not one of the recession indicators, since 1940, a steady deceleration in payrolls growth has generally been followed by a recession.

Strong U.S. Dollar is Unsustainable as it's a Drag on the U.S. Economy

While a strong dollar gives Americans more buying power for products made overseas, the appreciation of the dollar has a negative impact on U.S. exports of goods and services. The U.S. Bureau of Economic Analysis said in early January that the U.S. trade deficit surged to a 1-1/2 year high in November, as exports of goods and services fell 0.2% to $185.8 billion, while imports increased 1.1% to $231.1 billion. Exports, which have been on the decline since they peaked at $199.3 billion in the third-quarter 2014, went into a technical recession in the second-quarter 2015. Exports in the third- and fourth-quarter 2016 remained weak, despite a spike in U.S. soybean exports due to poor harvest in Argentina and Brazil.

U.S. Exports

Core Capital Goods

The U.S. Commerce Department said in December that the core capital goods new orders, nondefense capital goods excluding aircraft, also known as core capex, an important gauge of business spending, increased 0.9% month-on-month in November, but declined 3.2% year-on-year. Core capex has been in technical recession since the first-quarter 2015, when DXY began to trade in the 90 range.

Japanese Yen May Get Support From Weakening Yen Cross Rates

The GBP/JPY currency pair tumbled 1.73%, to an intraday low of 141.087 on Monday, after UK Prime Minister Theresa May told Sky News on Sunday, "We are leaving. We are coming out. We are not going to be a member of the EU any longer, so the question is what is the right relationship for the UK to have with the European Union when we are outside.". The GBP/JPY rally, which began after the Trump presidential victory, was rejected at the 147.06 yen resistance level, or 61.8% Fibonacci retracement, and may begin to fade.

GBP/JPY Cross Rate

The EUR/JPY currency pair, which also began its rally after the Trump presidential victory, stalled out between the trendline resistance and the 121.90 yen level, or 50% Fibonacci retracement. The currency pair could break down the 121.90 yen level, following the yield spread between the 10-year and 2-year U.S. Treasury Notes, which has already plunged over 10% since its peak in mid-December. The IHS Markit December Composite Purchasing Managers Index, or PMI, came in at a final 54.4, its highest rate since May 2011, but analysts warned that momentum in 2017 remains very uncertain, as it greatly depends on political events over the course of the next year.

EUR/JPY Cross Rate

Analysts at the Bank of Tokyo Mitsubishi said in late December that the yen is extremely undervalued at current levels. There could be some light at the end of the tunnel for the Japanese economy, as the Final Markit/Nikkei Japan Manufacturing PMI showed a reading of 52.3 in December, compared to 51.8 in November, the highest reading since January 2016, according to Nikkei Asian Review.

Conclusions

The U.S. dollar rally, which began after the November U.S. elections, could soon fade as the U.S. dollar might be highly overvalued, according to UBS. The strong dollar may be unsustainable when the U.S. economy is expected to only grow at a pace of 2.1% in 2017. The Trump administration's details and timelines for its big infrastructure and tax bills create "considerable uncertainty", as no one knows whether the plans will succeed or fail to meet market expectations. In our view, the Japanese yen could gain upside momentum against the U.S. dollar, and the gold price should resume its uptrend.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long bullion gold coins as an investment.