The re-rating of FED tightening path will prompt a recovery in the Yen hedged carry trade and lift USDJPY
Friday’s employment figures release can be summed up in one sentence: There is still a lot of slack.
I realized it on the spot and went long the NASDAQ when the figures came out. The market however took a few hours to understand the dovish implications.
<blockquote class="twitter-tweet" data-lang="fr"><p lang="en" dir="ltr">Took profits a few moments ago. it's been a good ride with like 96bps for me. my excel indicates we're a bit stretched on weekly gains (75% ile advance) which in light of the trade war problems looks good enough already. Happy friday to everyone and much gains. <a href="https://t.co/HMNsJMpxLc">pic.twitter.com/HMNsJMpxLc</a></p>— GreedCap (@greed_cap) <a href="https://twitter.com/greed_cap/status/1015263695113420800?ref_src=twsrc%5Etfw">6 juillet 2018</a></blockquote>
When the unemployment rate edges up while the economy is adding jobs, it means that the labor force participation rate has gone up. Workers who previously dropped out have decided that in light of perceived economic prospects, it might be worth it to start looking for a job!
In monetary policy speak, this means that the employment gap, and thus potentially the output gap, are bigger than expected. This hypothesis is very different from the working assumptions that have pushed the FED to hike for the last few quarters. The FED was hiking thinking: this is it, that’s all the juice we can squeeze out of this run.
There is also a lag of about 3 to 4 quarters for the impact of monetary policy to be felt (Bernanke 2009). We are thus facing a potential policy error because the FED might have hiked into an economy that can still absorb many more workers without any significant wage inflation. This is not something that the Powell led FED or the current administration wants to have anything to do with. My prediction is that this will prompt many at the FED to review their biases and favor a more cautionary and dovish approach(hiking 25bps every quarter for 3 years IS NOT easy).
If the market agrees with me and FED officials start to highlight this scenario in their speeches then this will lead the yield curve to steepen (through a decrease in short maturity yields and an increase in longer term yields). This combination is what is required for the USDJPY to rally via the carry trade.
When the Japanese invest in US assets, they ask for either positive hedged carry of about 1% or positive trend in underlying currency pairs. The two usually go hand in hand.
Let’s review how exactly the US/JP Carry trade works from the perspective of a yen denominated investors
- Use your yens to buy $
- Buy UST
- Hedge nominal exposure in forward market (usually each 3months)
(Note: There are more liquid and cheaper ways to do this but this is not the topic)
This portfolio exposes you to duration risk and re-hedging risk
Hedging cost depends mostly on US/JP short term rate differentials and this is where the pain was felt recently.
Breakdown of US/YEN Hedging costs, Source: DB Research
Fig15 shows the hedging costs: One the one hand, US monetary policy is responsible for the (US/JP) OIS gap and on the other hand, fiscal policy (remember that binge in short term treasury issuance? and Trump tax reform as well) is responsible for the recent USJP LIBOR-OIS explosion. All of that makes the USJP Carry trade a lot less popular and has resulted into the breakdown of one of the market’s most iconic correlations.
Yep. It just wasn’t the same anymore. 10y US Yield vs USDJPY, Source: TradingView
A quick explanation on why this correlation exists in the first place might be warranted: at some point the BoJ introduced a new policy named Yield Curve Control which as the name suggests involves controlling the Japanese yield curve by flattening it up to the 10 year sector.
In a world where short term rates didn’t really change at all, The combination of yield curve control and USDJPY carry trade justified this relationship.
Thus, if the curve steepens thanks to (but not necessarily limited to) a dovish re-rating in FED moves, then this will make hedged carry more interesting and partially fix the correlation between the 10y and USDJPY.
The VAT hike planned in October 2019 is nothing like the 2014 and 1997 ones in that it is accompanied by favorable policies that lighten the burden
Institutional Japan bears will tell you the biggest issue in the horizon is the 2019 VAT hike. This is a legitimate argument and the reason is simple : the last TWO times this happened it caused an immediate recession. I will refer the readers to the following article for the history lessons and in order to contextualize the current fears.
However, the actual resulting net burden will be modest this time because the VAT hike is accompanied by offsetting measures.
From the BoJ’s study on the topic [link]
On any forward looking metric, Normalized for growth, margins and for both at the same time, the Nikkei 225 is dirt cheap
Source: Proprietary work, Data from Bloomberg
The numbers talk for themselves. The NKY (Nikkei) looks unsustainably cheap when normalized for margins (PEM=NTM PE/margin) and this is because Japan inc. has staged a profitability revolution lately
Source: Yardeni Research
Japan inc. has also managed to lessen the Fx effect by making higher value goods whose demand is not as sensitive to prices, as you can see below/ as shown in chart below.
Source: BoJ Economic outlook
Source: Proprietary work, Data from bloomberg
The Nikkei seems due for a nice advance comparable to the advance enjoyed by US equities since they hit their bottom. This puts my target for the Nikkei225 index at 22556. Meaning a 90% ile advance from the local bottom.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.