The Yen's Riddled Road To 100

|
Includes: FXY, GLD, GTU, IAU, JYN, OUNZ, PHYS, QGLDX, SGOL, YCL, YCS
by: Ivan Martchev

My favorite finance professor in graduate school used to tell me: "Finance is not a science; it is an art." His point was that the interpretation of the numbers is the qualitative part that transforms understanding mathematics into understanding finance. The same numbers in one macro-environment can be interpreted one way, while they support the precisely opposite market reaction given another economic backdrop.

I do not believe that well-informed buy or sell decisions can be automated. I am aware of the parabolic rise in computerized trading (see Michael Lewis' bestseller "Flash Boys,") but in many respects that is beginning to look like a high-frequency bait-and-switch game. The most fascinating (and somewhat counterintuitive) moves in financial markets of late come from the currency and bond markets. In 2016, many expected bond prices to be lower and long-term interest rates higher, but the opposite has happened. (See my December 27, 2015 Marketwatch column, "Will 2016 Bring New Treasury-yield lows?")

In the currency markets, it is not the euro that is making headlines these days, or even the British pound, which I would have expected to be weaker, but the Japanese yen, which I had expected to be stronger. The yen's move last Friday to 106.3 (per U.S. dollar) is a fresh 52-week high, flying directly in the face of Japanese monetary authorities, who were experimenting with negative short-term interest rates - on top of a quantitative easing program that is 3X more aggressive than the Fed's relative to the size of the Japanese economy - to weaken the yen (According to Bloomberg.com, February 17, 2015, "Bank of Japan Keeps Record Stimulus as Country Crawls Out of Recession"). The negative yield on 10-year Japanese government bonds (JGBs) closed at -0.08% last Friday, after declining to as low as -0.13% earlier in April.

United States Dollar Japanese Yen Exchange Rate - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think the yen will move below 100 to the dollar this year, a substantial appreciation (the USDJPY cross rate is inverted, so fewer yen per dollar means a stronger yen). I think a further strengthening to below 100 may come, in part due to what I believe will be the coming Chinese devaluation. A Saudi riyal devaluation is also likely for related reasons, as the deflating of the Chinese credit bubble is likely to bring the oil price down to $20/bbl. after the present seasonal rally plays its course. (See my March 9, 2016 Marketwatch column, "What is behind the Yen's Monster Rally?")

Saudi Arabia Riyal Chinese Yuan Exchange Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think a Chinese devaluation is coming as the Chinese government would likely feel that it has no other choice as their ongoing credit bubble prevents the current monetary easing by the People's Bank of China from having the desired effect on the Chinese economy. (See last week's Global Mail, "The Chinese Hard Landing is Progressing on Schedule.")

Japan Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Since I believe that the coming Chinese devaluation and economic hard landing will have highly deflationary effects for the global economy, I would not be surprised to see the seemingly-absurd combination of 10-year JGBs moving further into negative territory and an even more expensive yen below 100 on the USDJPY cross rate. Negative short-term interest rates in Japan were supposed to bring about yen weakening, but we are seeing a completely opposite effect.

Nikkei 225 Index - Daily Nearest Line Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Based on where the yen closed on Friday and the apparent dynamics of unwinding carry trades - which for the time being are overpowering the BOJ - I expect further downside in the Japanese stock market. There is a very strong correlation between a stronger yen and weaker Japanese stock prices, as the famous Japanese exporters in the large cap Nikkei 225 benchmark index derive the majority of their profits from outside of Japan. A sharply stronger yen simply means less sales and earnings reported in yen terms.

Japan Interest Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This carry trade business that is driving the yen at present was made possible by the first zero-interest rate policy implemented in February 1999 when Japanese short-term interest rates first went to 0%. In normal times it is very profitable for a financial institution to borrow in the Japanese wholesale funding markets at very cheap interest rates and buy higher-yielding assets in other currencies, pocketing the interest rate differential. Japanese banks don't even need to go abroad to make money that way as long as there is a positive interest rate differential between JGBs and short-term interest rates, which is no longer the case for 10-year Japanese government bonds. Today, only 30-year JGBs have a positive yield (at 0.42%).

Such short-term borrowing of yen at exceptionally low interest rates gives any global financial institution the ability to buy other assets that have very little yield as the carrying costs of betting on higher prices are so low. Regrettably, when there is stress in the global economy - as we have now - such purchases of stocks and bonds with borrowed money unwind and there is a scramble to repay borrowed yen. In my opinion, this is why the yen's surge last Thursday and Friday was so pronounced, as most global stock markets and riskier bonds were under pressure.

Carry trades can only be done by financial institutions with access to wholesale yen funding markets and cannot be done by retail investors. It is not really a riskless endeavor as the yen exchange rate has made monstrous moves in the opposite direction of where the "fundamentals" would suggest. Such moves can result in sharp losses for carry traders that cannot see seemingly-counterintuitive moves ahead of time.

Finance is not a science after all.

Gold and Gold Stocks Don't Really Mix

I am starting to get questions about gold's role for individual investor portfolios as the sharp move in gold bullion this year has lit a fire under many gold stocks, many of which had experienced previous 80%-90% declines as the gold price corrected from $1924 in 2011 to the recent low of $1045 in December, 2015.

Here is the important point. The PHLX Gold and Silver Index (XAU, in green, below) reached a low of 40 in December 2015, matching its low in 2001 when gold reached a low of $255. The problem with XAU at 40 last December is that the gold price then was above $1000. The costs in the sector are out of control.

AUX Gold Index - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Hence, you need to differentiate between gold stocks and gold bullion. The gold market dropped in 2015 in anticipation of the Fed's December rate hike "fake out." That might be a real bottom, but I expect the coming Chinese and the likely Saudi devaluations will push the dollar to a fresh high in this cycle.

I suppose it is possible for gold to go up in a surging dollar environment, even though historically that has not been a good environment for gold bullion. Over the very long haul, gold bullion tends to go up as the policy of central banks create inflation of about 2% a year, which remains the Fed's stated target. That results in a constant decay of the purchasing power of the dollar. If dollars lose just 2% in value per year, adjusted for inflation over time, $1000 today shrinks in purchasing power to $42 in 100 years!

Consumer Price Index for All Urban Consumers Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Gold prices have historically been flat for 20 years (1981-2001), while gold companies have shown that they can go belly up in sharp sell-offs for gold bullion if their costs are out of whack. Investors constantly forget that a gold company is a leveraged investment, while gold bullion is a hedge against financial system instability - and a very good one at that. Those two are not one and the same thing.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.