Everything is topsy turvy in market land!
(Source: Disney's (NYSE:DIS) Hunchback of Notre Dame)
With the world on a global asset binge completely detached from fundamentals or valuation, naturally investors seek to know why. Some have blamed central banks, others blame the politicians; but all recognize a common theme - that the textbook theories of investment and macroeconomics seem to no longer apply.
As an example, we need merely look at global markets' post-Brexit hysteria:
- In the past few weeks, while U.S. equity markets have soared to new heights...
(S&P 500 Index)
- ... U.S. Treasuries have equally rallied driving down yields to record lows.
(30-yr Treasury Bond Futures)
- In Europe, as the ECB expanded its corporate bond programme and the FTSE & DAX reversed from their post-Brexit losses, the German Bund soared causing 10-yr yields to flirt with negative territory.
(SGI Daily Leveraged Bund)
- The Nikkei 225 soared nearly back to the 17,000 level...
(Nikkei 225 Stock Average Index Futures)
- ... on the wings of a depreciating yen, a key factor which we will explore further on.
(Japanese Yen Futures)
All of this correlation is not normal, especially when there has been no significant change in any economic data points (labor, prices, etc.) that would suggest any improvement in overall economic conditions. It's as if 'Risk-On' and 'Risk-Off' are playing out simultaneously in the backdrop of worsening international relations and isolative and illiberal politics gaining traction. Put simply, nothing makes sense anymore. So, what the heck is going on?
Let's start with a few principles of investment that are oft ignored but essential to succeeding long-term: (1) markets are inefficient and (2) people will always pursue the most bang for their buck, either unaware or indifferent to the likely future ramifications of said actions. The latter principle is key to our objective of trying to find out why markets seem to be so detached from reality.
From an economist's perspective, for example, it may be worrying to see markets straying from fundamentals or structural economic conditions remaining unchanged; but, from a trader's perspective, none of that matters. What matters is making profits... now. Regardless of whether or not it seems that governments everywhere are kicking the proverbial can down the road, as traders, we must chase the can... until it eventually falls off the (fiscal) cliff.
Keeping this principle in mind, let's look at some of the most important economic and political events in the past few weeks, paying attention to developments in Southeast Asia... particularly in the most important economy in said region - Japan. It's been a crazy few months, so take your time:
Important Recent Developments in Japan*
*with personal commentary added below each headline
- Jun. 6th, 2016: As his stimulus efforts struggle, Abe pushes 'equal pay' to lift Japan's economy
(Set the politically-acceptable backdrop for price and wage controls, i.e. 'equal pay'.)
- Jun. 13th, 2016: Economists expect Bank of Japan to expand stimulus, whether in June or July
(Allow the market to continue pricing in inflationary/expansionary policies despite being out of monetary ammo.)
- Jun. 17th, 2016: LDP vows all-out effort to boost Abenomics if it wins election
(Or, "vote for me or your pension/social security funds go bye-bye")
- Jul. 11th, 2016: Japan turns to Bernanke as fruits of Abenomics wither
- Jul. 11th, 2016: LDP-led ruling bloc, allies clear two-thirds majority hurdle in Upper House poll
- Jul. 13th, 2016: Japan to slash inflation forecast after repeated failure to kick-start growth
(Now that we've won, by the way, that sacred "2% inflation target" we worshipped for years...)
- Jul. 21st, 2016: Bank of Japan's Kuroda rules out 'helicopter money'
(Oh, and that Bernanke visit...)
Jul. 21st, 2016: Japan plans ¥20 trillion stimulus package to shore up economy, brace for Brexit
(But! We will add more unfinanced fiscal stimulus, including 'much-needed' construction and public works, and encourage agriculture exports!)
A Quick Response
(1) Now, if you know anything about Japan or have ever lived there, you can tell everything is a farce simply from the last sentence. The Japanese agriculture industry is extremely protective about its goods and it's one of the largest, most powerful lobby groups in the world. It's why you can never buy actual Japanese white rice outside of Japan and why it's about $50 for just a 10 kilo bag of rice within Japan. That Abe is now seeking to encourage agricultural exports is akin to his other grandiose claims that he will stabilize Japan's declining demographics. It's absolute hilarity.
(2) It's hard not to feel that the Bernanke visit was used for anything other than implied psychological manipulation of the markets in the run up to the National Diet vote. The BoJ has regular correspondence with Bernanke and other scholars and is quite aware of his various musings on the Japanese situation. However, much to my own chagrin, they have only ever half-heartedly taken his or others' suggestions to practice and usually far too late to be of any use, e.g. yen depreciation policy, unbound interest rate policy, etc. In fact, the BoJ is notorious for having been far too obstinate in the face of many leading scholars and trading partners encouraging... nay, begging Japan to pursue more accommodative monetary policy all the way back to the 90's.
(3) Take note of how the LDP's leading politicians and media pundits hyped up the possibility of more stimulus, particularly monetary stimulus in the form of so-called "helicopter money". It wasn't until after the results of the election that officials stepped in to set things back to reality, reiterating that true helicopter money was off-the-table and that stimulus-lite, i.e. more fiscal deficit spending, would be the actual policy du jour. In any case, Japan has been virtually using helicopter money for some time because the JGB market has been dead to actual investors for some time and it is only the BoJ and elite financial institutions that participate in the market; although, now, not even the financial groups want anything to do with it.
The LDP's chief communications officer doing what he does best...
Now, all of this macroeconomic musing is fine, but how does it apply to what we are asking: why are global markets so wonky?
The Carry Trade
For this, we need to understand one more concept: the carry trade. Carry trades are a simple concept - borrow in low-interest currencies to buy higher-yielding ones - but this simple strategy is now so critical to the high profitability of traders in the FX market. It is similar to other spread-capturing hedging strategies that funds use, such as LIBOR swaps. Here is a simplified overview of the process below.
- Borrow the yen at an extremely low interest rate.
- Convert the yen to dollars.
- Invest said dollars in higher-yielding securities such as U.S. Treasuries. The spread between the Treasury yield and interest cost for the borrowed yen is called the "yield premium" or "positive carry".
- Bond prices rally further intensifying the effect...and short-term profits.
- Re-invest a portion of profits into actual assets, e.g. equities and commodities.
Seems great, right? Not so much, the discerning long-term investor should say.
Not only is there considerable interest rate and exchange rate risk involved (especially if leverage is involved), over time, the continuous bond rallies, while positive for short-term profits (as large hedge funds can offload their bond holdings easily in case 'Risk-Off' sentiment diminishes), are terrible for long-term economic and investment prospects. As prices inexorably rise, yields fall in proportion. You can see where it all starts to fall apart - over enough time, the premium disappears especially if yields are pushed into negative territory causing various dysfunctions.
This is the fallacy of the "currency wars" and "beggar-thy-neighbor" policies. The forex arms race that inevitably ensues eventually ends up hurting everyone in the end and contributes nothing to real growth in the global economy. Yields can only fall so low - negative interest rates can only go so far - until reality catches up with the system. Hedge funds and other large investment vehicles can enjoy the windfalls of this cheap trade now, but in the end, depreciative currency policies have done nothing to stimulate real growth or re-encourage capital investment.
This carry trade phenomenon, I think, is also what is responsible for markets behaving so divergently from normal patterns lately. Hype over more monetary stimulus or "helicopter money" from the Bank of Japan drove the specs to temporarily dump the yen in anticipation. Not only did the depreciative yen drive a rally in Japanese equities but the windfall from carry trades that inevitably ensued from a weakening yen allowed hedge funds and other major funds the ability to re-invest into the global equity markets and other asset classes further pushing the rally to new heights, even as markets were simultaneously going into 'Risk-Off' mode and buying up more Treasuries in anticipation of worsening economic conditions and the subsequent necessary announcements of stimulus...in one big reinforcing super-cycle!
Perhaps The Heisenberg describes this phenomenon perfectly, far better than I ever could:
If you want to know just how sure everyone is that monetary policy will be able to keep the party going, just look at hedge fund positioning:
(Source: Société Générale)
Those are all faith trades on central banks. Every single one of them.
The curious thing, however, is that when you look out across FX sentiment do you know what you'll find? Yen bulls - lots of them.
(Source: Deutsche Bank, CFTC)
That should strike you as odd. Think about it: the very same people who are betting on a continuation of a rally sparked by hopes that Japan will launch helicopter money and thus drive yen depreciation are... drum roll... long the yen.
They're betting against themselves. And do you know why they're doing that? Because they don't believe helicopter money will work. But that's the whole thesis for being "particularly positive" on the 30Y (NYSEARCA:TLT), the Nikkei, the S&P (NYSEARCA:SPY), etc! It makes no sense. It's contradictory.
-- The Heisenberg
Put simply, everything is topsy turvy! And when you get down to the crux of it, it's all courtesy of the LDP doing what they always do best, manipulating the Japanese public to further their own agenda. But, hey, we're just traders, so if the king says "Eat up!", we must feast!
Come and join the feast of fools!
(Data images sourced from TDAmeritrade's thinkorswim platform)
Disclosure: I am/we are short SPY.
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.