Dollar, Oil And U.S. Investment Strategy

Currency and commodity markets are having overdue technical countertrend moves after moving a long way in a short period of time. “One-way bets” are over. Price moves in the other direction will be violent given the crowded nature of these trades, but, according to our U.S. investment strategists they will not prove sustainable.

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The trade-weighted dollar and crude oil prices exhibit all the signs of major technical extremes. Spot prices are far away from moving averages. Intermediate-term momentum indicators have been stretched for several weeks. Trading sentiment is lopsidedly optimistic on the dollar and equally pessimistic on oil. Speculators are long the dollar, although oil positioning is less clear owing to lack of speculative positioning data for Brent futures prices. Nevertheless, oil market open interest remains high even after the recent bloodbath. Market-positioning extremes on this order of magnitude suggest that these trends are overdue for at least a pause. However, they do not provide insights into whether the underlying trends are reversing.

For the dollar, relative monetary conditions between the U.S. and the rest of the world continue to diverge. Fed hawks and doves still have a mid-2015 rate hike in their sights. In contrast, rate cuts and QE are the default setting in most other developed and emerging countries, with rare exceptions like Brazil. Policymaker attitudes towards their currencies also continue to diverge. Fed officials emphasize the transitory nature of the strong dollar’s impact, while Abenomics in Japan has a weaker yen as an unofficial target.

For oil, prices may not have much more downside, but we expect more volatility than price recovery.

JAPAN: Structural Reforms In Focus

Wondering about the status of the third arrow – structural reform – of Abenomics? Today, we are pleased to offer an update on what the next eighteen months could bring in Japan.

By obtaining an electoral mandate from voters, PM Shinzo Abe, will, in the coming 12-18 months be able to side-step the institutional and popular political constraints that have weighed on his reform agenda.1 The back-to-back sizeable election victories for Abe are actually unprecedented in post-crisis Japanese politics.

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The election was billed as a referendum on Abenomics, ensuring that PM Abe will now continue to use policy levers that push Japan toward stronger growth and stable inflation around 2%. We maintain that the resounding re-election of Abe should be positive for Japanese risk assets.

Since the Bank of Japan has essentially defined the path for monetary policy in 2015, the focus of the government will shift toward structural reform. In this regard, the substantial election victory for Abe is important because it will limit the ability of both LDP members and government bureaucrats to impede his reform agenda. The coming 18 months will include the passage of several important measures. Some notable areas of reform will include:

  • TPP Negotiations: Reaching an agreement on the TPP trade negotiations is critical to PM Abe’s structural reform efforts. A final agreement would liberalize several protected and inefficient Japanese sectors, including the health care and agriculture sectors.
  • Labor Market Reform: Critical to the success of Abenomics will be improving the country’s labor market. The main target of reform in this area should be reducing labor market duality, i.e., the existence of a two-tiered system of permanent and non-permanent labor markets. The Abe administration has not yet signaled how aggressively it will push forward in this area, so we will be watching this issue closely during the upcoming Diet session, starting on January 26th, 2015.
  • Corporate Tax Reform: After its re-election in December, the Abe government agreed to lower the corporate tax rate in Japan from 34.6% to 32.1% in April 2015, and to 31.3% in April 2016. PM Abe is also committed to reducing the corporate tax rate to below 30%, so we expect more movement on tax reform in the coming session of parliament.
  • Nuclear Power: Restarting the country’s idle nuclear power plants has become less important as oil prices have collapsed – the IMF estimated in its October 2014 World Economic Outlook that Japan is most exposed to a growth shock from changes in crude prices. Nonetheless, we expect that the government will continue to push regional authorities toward re-embracing nuclear power.

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Structural reforms will do much to help boost growth and asset returns in Japan. However, as former Vice-Minister of Finance Eisuke Sakakibara – known by most in finance as “Mr. Yen” – described in his 2003 book on the issue, reforms must cut deep and will take at least a decade to complete.2 The good news is that after several decades of deteriorating economic activity and rising discontent with their livelihood, Japanese voters finally seem ready to accept a political leader that is willing to push hard for change.

 

Footnotes:

1 Please see BCA Geopolitical Strategy Monthly Report, “The Reflation Era,” dated December 10, 2014, available at gps.bcaresearch.com.

2 Please see Sakakibara, Eisuke, Structural Reform In Japan: Breaking The Iron Triangle, Brookings Institution Press, Washington, D.C. (2013).