As I began writing this post yesterday, equity markets once again decided to remind us that they can go down as well as up. Previous posts have noted the rising danger in the fundamental picture via rising inflation, and the potential for higher rates (see ’99 Redux ). Yesterday’s fireworks should be a wake up call as to how sensitive markets may be to higher rates. I hope to give an update on that soon, but for now, I want to continue with some thoughts on FX.
The Dollar Moves Everything
Over the past year, the U.S. dollar (DXY index) has had a drop of about -13%. In a world where Bitcoin is the most talked about market entity, and is moving more than 10% in a day (see Bitcoin’s Greater Fools ), such a move does not grab investors’ attention. But movements in the U.S. dollar can have profound effects, or at times, may be indicative of important events happening under the hood of the global economy. As the world’s premier reserve currency, most trade takes place in dollars, commodities are priced in dollars, and more debt is owed in dollars than any other currency. Therefore, moves of 10% or more in the U.S. dollar are quite meaningful. A weaker dollar tends to indicate better global liquidity, and often coincides with better performing global risk assets. For U.S. equity markets, large multi-national American companies get a boost from earnings when the dollar is weaker.
As outlined previously (see FX Dynamics Part 1: Dollar Weakness ), the majority of the dollar weakness has been driven by the Euro. On the other hand, the Japanese Yen, which is the second largest weighting in the DXY, has only strengthened about +6% since the beginning of last year, versus over +20% for the Euro. This differential is not a huge surprise in light of the extremely positive environment for risk assets. The Yen tends to perform best when markets get hairy. When global markets are buoyant, the Yen may be falling, or have no particular correlation. But when fear is in the air, and markets are dropping significantly, and persistently, the Yen virtually always rallies.
Yen as Safe Haven
Market correlations vary over time, as fundamental relationships change, and market positioning shifts. Generally, the inverse relationship between the Yen and global risk assets in major risk-off episodes has endured for well over a decade. It is possible that the extraordinary monetary stimulus the Bank of Japan (BOJ) may have changed the previous correlation. However, we have not had a major selloff in global markets since the precipitous drop in August of 2015, which carried over into early 2016. At that time, the Yen, contrary to previous risk-off periods, remained somewhat steady during the initial sell off on global markets, then appreciated around +20% as heavy short positions were squeezed. The lag in the move was somewhat abnormal. Normally, in similar episodes, the Yen would have moved simultaneously with a market sell off. It’s quite likely that market participants initially believed the enormous stimulus provided by the BOJ would continue to keep the Yen weak.
I think it’s important to address the reasons the Yen usually appreciates during global sell offs. At times, the Yen is described as a “safe haven” currency, which I believe is a bit of a misnomer. For twenty years, the Japanese economy has been a basket case. Following the incredible bubble Japan experienced in the late 1980’s, they have experienced decades of deflation. Much of the deflation is a secular phenomenon driven by a horrible demographic profile. Japan’s working age population (ages 15 to 64) has been falling since 1993. Working age population has collapsed from almost 70% to around 59%. Absent increasing productivity, this leads to a lower trend economic growth rate. Lower trend growth has made it more difficult to service extremely high debt loads that accumulated during the bubble. This situation is known as “debt deflation” (see Debt Deflation ). It was prevalent in the Great Depression, and is the nightmare of every central banker.
Another element of Japan’s economy which exacerbates its debt deflation is that Japan, like most Asian countries, has a high rate of savings. Higher savings rates, while providing an economic cushion, lower near-term growth. Decades of weak domestic demand is evident in excess savings, which goes hand in hand with current account surpluses, and has led to Japan owning an enormous amount of foreign assets. In effect, this is the key to the Yen’s inverse relationship to risk assets during market panics. During global risk-off episodes, many Japanese investors will sell foreign assets, and repatriate funds back to Japan. Or, those that do not sell may hedge their currency exposure. Either way, buying pressure is exerted on the Yen; which explains why it typically appreciates during global panics.
A Timely Macro Hedge
In my previous post, I introduced a fundamental indicator, the F-FX, which is designed to signal whether a currency is expensive or cheap (see FX Dynamics Part 1: Dollar Weakness ). Chart 1 shows the Yen (vs. U.S. Dollar) normalized against the F-FX indicator. Similar to charts of the Euro and DXY shown in the previous post, the two series tend to move inversely. When the F-FX is relatively high (say +50), the currency is poised for appreciation, while low readings presage depreciation. Prior to the market turmoil in the last few days, there has not been a period of extraordinary volatility since late summer 2015 through early 2016. As noted previously, the Yen remained somewhat depressed initially, during that period as traders/investors continued to believe the record liquidity provided by the BOJ would keep the Yen depressed. However, as the F-FX indicates, the market was leaning very heavily against real economic factors that were exerting bullish pressure on the currency.
Chart 2 shows the technical picture for the Yen in terms of positioning using Yen futures data from the CFTC. Using net speculators as a percentage of open interest as a positioning proxy, we can see that prior to the strong rally in the Yen in 2016, positioning was quite bearish. Net speculator positions registered -40% of open interest while the F-FX indicator was at 94. That combination of bearish positioning and strong fundamentals subsequently led to a Yen rally of almost +20% over the next six months!
Present positioning and fundamentals are not as strong as they were at the beginning of 2016. Nevertheless, they indicate a meaningful bias toward Yen appreciation. Net specs are -37% of open interest, which is a somewhat crowded position. Coincidentally, the F-FX is at +37, the mirror image of net specs. While not an extremely positive reading, it is down from 69 in November. Often, once the trend shifts for both net specs and F-FX, they move to the opposite extremes. Assuming global markets stabilize in the next few days (or weeks), any Yen appreciation may be somewhat slow. But given the normal reaction of the Yen to global market panic, a long Yen position could act as an effective macro market hedge. Whether in the next few days, weeks, or months, that may come in handy.