Gold, Bond Yields, And The Japanese Yen All Say There Are Problems

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Includes: FXY, GLD
by: D. H. Taylor

Summary

Japanese Yen, gold and Bond yields all move correlated.

Bond yield moves lower suggest financial concerns lurk.

Super Thursday has gotten small relief rally, but the bigger problem still lurks.

Money is flowing. Currencies are moving, bonds are heading higher - yields falling, and gold is up. These moves are typically based upon risk-aversion. As investors "run for the hills", out of equities and into the relative safe-haven status of Treasuries, this pressures yields lower. That forces the carry traders out of their positions, pushing the Japanese yen higher. And, all of this pushes gold higher. Market participants have called today "Super Thursday" with the ECB meeting, the British election and the Comey testimony. If all three of these events end up being benign for the market then traders can expect a turnaround altogether…. either that, or there is something far bigger driving the markets.

If you look at a chart of both the Japanese yen with the 10-year for the past six months the two are mirror images of each other. The fate of the Japanese yen is tied heavily with the interest rates of various currencies around the world. In fact, if you overlaid the Japanese yen on top of the 10-year government yield for Australia, Canada, United States and United Kingdom, without labeling the charts, you would be hard pressed to determine which chart is which. Here they are, respectively:

The Japanese yen is the blue line in all of these charts and the black line is the respective country's 10-year government bond yield. You are actually looking at USDJPY, the inversion of the Japanese yen. If USDJPY moves downward then the USD is moving lower and JPY is moving higher.

What is going on is that Japanese citizens are notorious savers - Japan has a savings rate of approximately 14% versus the United States at slightly less than 5% - but, bond yields in Japan is near zero. So, in order to squeeze as much orange juice out of a rock as is possible, the Japanese have become savvy bond yield chasers investing all over the world.

In Japan, the Bank of Japan has been pushing diligently to keep their long term interest rates at, or near zero. The yield on the 10-year Japanese government bond is yielding 0.06%. In the respective countries, the 10 year yield is as follows: Australia 2.40%, Canada 1.41%, the United States 2.18% and the United Kingdom 1.00%.

There is an ongoing trade called the "carry trade", where anyone who carries a currency position over the New York fix either pays or is paid the difference between the lower yielding currency versus the higher yielding currency.

For example, if you were long AUDJPY, you have purchased the Australian dollar and are short the Japanese yen, and vice versa for a short position. With the 10-year yields what they are you are paid the differential, or difference between Australia's 2.40% and Japan's 0.06%, or 2.34%. That number is the annual rate and you are paid for that long position for one day's worth of that annual rate. If, however, you are short the cross rate, you are going to pay the individual on the other side of the trade.

Please note, for the carry trade, the 10-year is not used as the actual rate but instead it is an average bank rate that your brokerage has an agreement with. Also, speaking of brokers, they want their cut; You are not actually going to get the full difference. There is a bid/ask for the AU interest rate as well as the bid/ask for the Japanese interest rate. But, for simplicity, the 10-year gives you a decent idea that there is a substantial difference between the yields.

The carry trade is a very large and viable trade bringing billions into the trade. The only problem is that the carry trade depends upon a widening interest rate differential. If the interest rate differential narrows, the trade is unprofitable and you would exit the trade. Again, this is why currencies move.

Right now, interest rates around the world are moving lower. Because of that, money is flowing out of the United States and other countries back to Japan; the carry trade is unwinding. That explains why the Japanese yen is moving higher because interest rates in the long end of the curve are heading lower.

There is another relationship that is tied together very closely, that being the relationship between gold and risk aversion. If bond rates move lower around the world, the Japanese yen moves higher and gold moves higher as well. Here is a chart showing gold (Bar chart) and the Japanese yen (red line) both moving in lock-step over the past several months starting about October on this chart:

There has been a small disconnect between the relationship of the risk aversion move with the Japanese yen and gold - a savvy hedger would be able to take advantage of that. However, relatively speaking the two have moved in fairly lock step on a percentage basis over the past several months. Neither leads the other.

What is happening is that money is moving and adjusting. While the equity market continues to tap on the all-time high ceiling, the rest of the investment world is seeing risk and averting that risk.

Super Thursday

I am not sure who coined this phrase, but Thursday, June 8th, is being dubbed "Super Thursday" due to three large events: The ECB Meeting, The British general election and the Comey testimony before congress. At the time of this writing, the results of 2 of the 3 are largely known, the ECB meeting results and the British election results.

The ECB has lowered its inflation guidance all the way into 2018. The guidance was inflation will be lower than their target of 2.00%; below what the market has been expecting. Inflation around the world has moved higher but more recently has been subdued.

The world was expecting the ECB to become more hawkish - I had the same expectation. That would have driven interest rates higher. Interest rates on government bonds moving lower ahead of this meeting does not explain the current outcome.

Even more, the Federal Reserve is in the process of raising interest rates. The Fed is also in the process of shrinking its balance sheet. By shrinking its balance sheet, the Fed will no longer be purchasing longer-dated maturities. That, in theory, would allow bond yields to move upward on the longer end as there is a large purchaser of bonds will be missing in the marketplace. Again, bond yields should have gone upward, not downward, as they are. Both of these inputs, the ECB's potential of being hawkish, as well as the Fed's new policies should have pushed rates higher, but, this is not happening.

The second event, the British election, I cannot for the life of me see how there is much risk in this affecting the market. Britain voted to jump off the face of the planet. The financial world has known that for just shy of one year. If the election is an absolute train wreck, would this really affect American bond prices? Not so much, I do not think. Britain's fate, at this point, is their own. If anything, I could see British bond yields heading higher, creating an appeal for an investor. But, mostly, I think despite whichever party may win the majority in an election, all would agree that doing what is best for Britain is best for Britain. Their negotiations are going to be difficult, regardless. This election will not be the make-or-break event for the country and its future. That already happened when the country voted to jump off the face of the planet last year.

The last event is the Comey testimony. This one event may have the potential to rock the markets somewhat. My thinking on this is that the world probably knows what likely has transpired and nothing earth shocking will come from the testimony itself. There was a pre-release of the opening statements by Comey from the Senate committee just last night. There was nothing really of note there. Comey's full testimony is likely to be the same.

Is something lurking in the dark?

Bond yields have move downward too much for what everyone is calling Super Thursday. There must be a strong flow coming from somewhere else and from another reason altogether. My best guess: China. China is the world's biggest financial catastrophe about to happen. And, everyone is wearing blinders over this issue.

China has a massive credit problem, far, far bigger than anything seen previously and big enough to make the 2008 financial crisis look silly when their credit default implodes. The ratios on China's debt:GDP make the United States in 2008 ratio look small, by comparison. For now, the government is addressing the issue.

But, the weight of the government's policies to correct the credit imbalance have been weighing on the financial markets in China with downward moves in their currency amidst upward moves in the Chinese government bond yield.

Whether the movements in the bond yields are indicative of the three risks involved going in to today's market are yet to be seen. Now that these risks are out of the way, there should be moves upward in the bond yields. If not, it is very possible that there are larger problems pushing money into safe haven assets.

I expect mild amount of relief in the bond yield after this so-called Super Thursday. After that, I expect we will see what is really pushing interest rates lower.

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.