Category Archives: JPY

GBPJPY hitting selling area

Forget about Brexit for the moment. We don’t know what it will look like, when it will happen or what the global story will be when it does happen. Let’s just look at where the currencies and economies are now, and ask if that position makes sense. In the case of GBPJPY, it doesn’t.

The market is being asked to finance an annual  relative current account position between the UK and Japan of more than $300bn in Japan’s favour, but is being offered no real yield advantage to do so, and GBP/JPY is already relatively expensive relative to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

GBPJPY is currently trading around 152. Is that high or low? Well, if you just look at a normal chart, you might think it’s low, because GBPJPY has been falling for the past – well – forever. Even in the past 20 years it has round about halved in value. Though it is around 30 figures above its all-time low (see chart below).

gbpjpy

But this is entirely a nominal picture that ignores inflation. Most of the reason for GBP/JPY’s decline in recent years has been the higher inflation in the UK relative to Japan. The easiest way to illustrate this is to look at GBP/JPY relative to GBP/JPY PPP, as shown in the chart below.

 

gbpjpy and ppp

Source: OECD, FX Economics

So although GBP/JPY has been falling steadily, it is now trading above PPP, and is further above PPP than its average over the last 20 years, as shown in the chart below.

gbpjpyppp

Source: OECD, FX Economics

So, in real terms GBPJPY actually looks quite high compared to history.

Is this justified? Looking at the data, the simple answer is no. UK real yields are not relatively attractive. At the 10 year tenor, the nominal spread is 1.2% in favour of the UK. But the inflation differential in 2017 was 2.6%. Even though this is expected to narrow in 2018, it is still expected to be 1.6% according to OECD forecasts. So real yields actually favour Japan and the JPY (even more so at the short end of the curve where nominal spreads are smaller).

What about other determinants of cross border flows? The current account position implies a need for a cross border flow, and the UK was in deficit in 2017 to the tune of about 4.7% of GDP, while Japan was in surplus by 3.9% of GDP. This difference is only expected to narrow very marginally in 2018.

So the market is being asked to finance a relative current account position of more than $300bn, but is being offered no real yield advantage to do so, and the currency is already relatively expensive to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

If we add Brexit into the mix, it’s worth noting that GBPJPY is now above the high it traded the week before the Brexit referendum. Whatever you think about Brexit, it is pretty hard to argue that it currently justifies a stronger currency.

So much for valuation. But a large part of this story is about the weakness of the yen rather than the strength of sterling, and the weakness of the yen has historically been well correlated with positive risk appetite, reflecting the historic tendency for the surplus country to be keener to place money abroad at times of positive risk sentiment. But this makes far less sense than it used to when the real yields available outside Japan are no greater than the yields available inside Japan.

So it seems to me that these represent excellent levels to sell GBPJPY for the medium to long term. For the technical minded. 153.80 represents the 76.4% retracement of the move from the 164 May 2016 high to the 123 October 16 low.

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The value is in EUR

The short term focus in FX has been on central banks. The lack of BoJ action,  diminishing expectations of action from the Fed, and the ECB approaching the limits of easing have all contributed to a strong JPY and EUR and weaker USD, while today saw the RBA sucked into the anti-deflation battle once again, halting the AUD recovery. The rationale for focusing so much on minor changes in central bank policy seems to me to be very flawed, and the scale of the reactions on the face of it looks excessive. But what appears to be excessive volatility in reaction to minor news may in fact be something else. It may be a reflection of very out of line initial valuations. As the market’s love of the USD and the story of widening yield spreads fades, recent sharp moves may reflect a realisation that valuations may be a long way out of line if the focus is changing. This is important for anyone looking beyond the short term, and even short term traders should be aware that with the long term USD uptrend under threat, the dominant paradigm may be shifting.

The simplest way of looking at value in FX is to consider real trade-weighted indices. These provide a comparison of the real value of currencies over time. I have put together a chart using BIS data rebased to February 1987 – the data of the Louvre accord when the major countries tried to stabilise currencies. This is not necessarily representative of fair value for reasons I will elaborate on later, but is a reasonable place to start. On this basis, the JPY looks the cheapest of the major currencies, and the Swiss franc the most expensive. The USD went from cheap in 2013 to expensive by the end of 2014 and extended its valuation though 2015. GBP also looks expensive on this basis, albeit a little less so than it was, while the EUR is on the cheap side.

realeffectives

But valuation on this basis misses out two key factors. First, the possibility of structural change and second the cyclical movements in currencies that result from movements in yield spreads. Of course, the latter is by its nature a temporary phenomenon, and cyclical movements in currencies always looks excessively volatile based on yield spreads. The increased attraction of higher yields makes a currency more attractive, but currency moves typically substantially overcompensate for the increased expected return. This is why a change in market sentiment can conversely produce an apparently excessive reaction in the opposite direction, as in the recent move in the JPY.

However, structural changes can and should have a sustained impact on currency valuations. I tend to look at this in terms of movements in the current account. Currencies with big current account surpluses tend to be more highly valued than those with a deficit, as a current account surplus represents a persistent flow into the currency which needs to be offset by capital flows in the opposite direction, encouraged by a higher currency. Changes in the terms of trade are one major factor that can change the structural current account position, but other factors can also have an impact.

In the current situation, the most notable current account changes in recent years have been the rise in the Eurozone current account surplus, the rise in the UK deficit, and the decline, and more recently recovery, in the Japanese surplus. These are important changes, because the history of the real exchange rate index has to be coloured by such structural changes. So the weakness in the JPY we have seen until recently was in part justified by the deterioration in the Japanese current account position. However, the recent improvement suggests some scope for the JPY to recover, especially since the weakness had in any case overshot somewhat. Meanwhile, the big rise in the Eurozone current account surplus justifies a stronger EUR valuation, and the converse is true for the UK.

Now, movements in the current account are also cyclical, with stronger growth economies typically having bigger deficits, and cyclically improving current account positions are not normally positive for a currency, because they are usually accompanied by independent capital outflows towards higher growth economies, usually because of higher or rising yields. But when the relative growth underperformance stops, the surplus doesn’t quickly disappear, and the surplus may become the dominant factor. This is the situation now in the Eurozone. The EUR not only looks cheap on valuation, it is even cheaper when the recent current account improvement is taken into account, and currently the Eurozone is also actually growing faster than the US or the UK (at least in Q1 2016). So something of a perfect storm for the EUR.

As for the JPY, while it looks the cheapest currency compared to history, it is probably less cheap than the EUR when the recent structural changes are taken into account. This is illustrated in the chart below.

 

valuemodel

So in the longer term I would see plenty of further upside for the EUR. However, in the short to medium term, the USD and GBP could recover if relatively strong US and UK growth returns and yield spreads resume the widening trend. Nevertheless, while his could happen in the next few quarters, I see little scope for this to continue longer term as cyclically adjusted budget positions in the US, and particularly the UK, need to be reined in. In comparison, the Eurozone has potential to expand budgets being that much further below trend output and full employment.

 

Supertanker turns?

EUR/USD is a supertanker. It takes a lot to turn it, and yesterday’s break higher was long overdue, as the European data had been steady and the US data deteriorating for some time with little impact on the currency. Whether this is a proper long term turn depends on how much trust we can place in the evidence of weak US and more solid Eurozone data and whether we believe that Draghi has more ammunition to halt the EUR recovery. I suspect we aren’t quite ready to believe that the US recovery is burned out so long term EUR/USD gains will have to wait. But even if the supertanker hasn’t made a longer term turn, it doesn’t reverse these sort of moves quickly. While rapid moves of this sort are often corrected for a period before extending, I would still be looking to buy a big enough dip. Technically, we have now achieved the 61.8% retrace of the 1.1495 to 1.0525 October to December decline, so I wouldn’t be chasing it as we may well see some retrace, but I think it will take real news, and not just a decent employment report tomorrow, to get us back below 1.10 with major supports now at 1.0980 and 1.0940. People may start to remember that employment data often lags the cycle.

For what it’s worth, I doubt that he US economy is really weakening dramatically. The data is unreliable in the short run and the short term impact of a weaker oil price may have been negative, but longer term effects are more likely to be positive. I wouldn’t rule out a rate hike this year, despite the latest market moves, though again, we need to see some numbers to get the market thinking that way again, and they aren’t going to turn up immediately.

Of course, Draghi won’t be happy to see EUR/USD spiking higher, and its rise will give him some ammunition to persuade the ECB Council that more easing is required. If he gets the desired further ease, EUR/USD will settle into a range again. I’m not sure he will but the market is probably going to bet on it ahead of the March meeting, so I think other currencies where easing is less likely are more attractive USD alternatives. The JPY is one possibility, and the easing has already been done so another move near term is unlikely, but you have to back weak equities to favour major yen strength. It’s quite possible, but I’m not quite ready to do that as even though the US data has been disappointing, equities get the comfort of lower yields, and European data has been less of a concern. I’m keener on the AUD, which looks ripe for a recovery if commodities stabilise, and the SEK, where the Riksbank’s threats look empty with EUR/SEK pushing 9.40 and growth remains the strongest in the developed world.

 

Risk off – why EUR/JPY?

Yes, the Chinese data has been a bit soft, and the US manufacturing numbers haven’t been too special either. Plus we had the North Korean “earthquake” to jangle some nerves. But the European PMI data has been solid enough, and the US employment data continues to impress. The oil price is hitting new lows, but that’s double edged for growth and equities. It’s not all great, but it doesn’t all look terrible either. In my book it’s not bad enough to create a major sell off in equities. Yet we are at the lowest level since October. In the US, this may make some sense. Rates are higher and the recent data has been on the disappointing side. But for some European markets, the price action is harder to justify. Sweden in particular is testing the October lows which were also the 2015 lows, but rates are negative in Sweden, the currency is still very low against the USD, and growth is running close to 4% and expected to hold there for 2016. It’s hard for European markets to buck the trend of the US, but it’s hard to understand them underperforming.

This is also reflected in a bit of an FX puzzle. EUR/JPY has been hammered in the last few sessions, but the EUR doesn’t look the obvious currency to suffer from risk aversion. The European numbers have been reasonable, but  in any case, the EUR has tended to benefit from risk aversion in recent months, which makes sense given that it has been the favoured funding currency. AUD, CAD, GBP, USD and NOK all look more obviously vulnerable to risk negative news.

On a fundamental basis, it is also hard to justify EUR/JPY weakness on risk aversion, as the Eurozone is now the biggest current account surplus region, and positioning remains more heavily short EUR. It may be that the ECB does eventually ease more, but at this stage the BoJ is still implementing QE even more aggressively. Valuation wise, I would argue that the EUR is also slightly cheaper than the JPY, and though some will disagree with this assessment, valuation isn’t a major issue. All in all, I can see no real case for major EUR/JPY weakness with the obvious equity correlation looking harder to justify. Yet we are approaching the 2015 low at 126.10. It’s hard to oppose current momentum, but seems to me this should hold until there is clearer evidence of risk aversion extending. So even though the chart looks pretty compelling in favour of the longer term JPY bulls, I’d look for a near term bounce.

 

Sterling – is the good news in?

The next few months up to the UK election offer significant downside risks for GBP, especially against the EUR and JPY.

Sterling has benefitted over the last couple of years from the UK’s relatively strong growth performance even though this has yet to deliver a rate hike or even a real near term expectation of one. To be honest, I think the Bank should have hiked rates already – the excuse that inflation is currently low doesn’t really wash, as on the 2-3 year horizon the current weakness of inflation will lead to higher inflation assuming the oil price stabilises or rises from here. Stronger demand due to the current low oil price will help boost growth, wages and inflation going forward, and should provide a good case for higher rates after the election.

But while I think the Bank should have raised rates already, the fact is they haven’t, and are very unlikely to move this side of the election. So until after the election, most of the good news does seem to be in, and abstracting from the run up to the Scotland referendum, there may be some severe electoral downside risks that could take hold quite quickly even if the risks appear to be well known.

The polls are unclear, but a Labour/SNP coalition certainly looks a very possible outcome. I suspect this is not something the market would greet with open arms. The concern is that a focus on taxation of the wealthy could undermine capital inflows into the UK, and even if this were only temporary, it’s a dangerous prospect for the  country with the biggest current account deficit (as % of GDP) of all the majors.

Now, the pound is very strong against the EUR and the JPY, so these are the currencies against which it may be most vulnerable. The EUR in particular is at levels which are equivalent to sub-0.70 pre-crisis in real terms given the high UK inflation rates in the meantime. The risk premium in the EUR certainly looks justified given the Greek uncertainties, but may diminish on a temporary deal and both the Eurozone and Japanese economies will benefit even more from the decline in the oil price than the UK.

It may well be that UK rates do rise earlier than the market currently expects, in which case there may be a sterling buying opportunity after the election. The trouble is that the factors that make sterling attractive are also the seeds of its destruction, because relatively strong UK growth has created the big current account deficit. This may not prevent another sterling rally, but I think it will have to come from lower levels. Right now, the risks are on the downside, and I like selling GBP/JPY to avoid too much commitment to the Eurozone recovery story. Look for a dip sub-170, with 188 a good stop area.