Will USD/JPY Finally Break?

USD/JPY has been frustratingly stable but our bias is to expect it to break lower:

USD JPY

  • The BoJ kept policy on hold last week and gave no indication that it is about to increase its asset purchases.
  • Valuations are stretched. Our PPP model says that USD/JPY is overvalued by more than 20%
  • Positioning and sentiment indicators show excessive pessimism towards the yen. Long Nikkei/short yen trades have made no money for investors over the past year. Investors may be losing patience with this trade and may cut their positions at the first signs of trouble. This could cause a cascading effect as stop-losses get triggered, leading to further selling.

Bottom Line: Fundamentals and technicals point to a downside break in USD/JPY. Also, as last week’s events in Ukraine/Russia highlight, global risk aversion can spike without warning. Shorting USD/JPY serves as a valuable hedge to portfolios.

U.S. Employment: Trust The Data

Today’s payroll report, combined with the ISM reports, suggests that the U.S economy is back on track after a weak start to the year.

US Employment - Trust The Data

The labor data and ISM surveys paint a much more upbeat picture than other recent economic releases on the demand side (notably, consumer spending reports). Which is telling the right story? Our bias is that today’s payroll report is a good reflection of the current state of the U.S. economy.

The ISM data is relatively free of revisions, and the BLS payroll data is generally considered to be of higher quality than other official statistics.

At 288 000 monthly payrolls in June, and upward revisions to previous months, the job market is on a decent – albeit not stellar – trajectory. The main positive points in the report are that the employment gains are broad-based across sectors; there were notable gains in “high-quality” jobs such as financial services, and other professional and business services; and the unemployment rate fell on the back of a flat participation rate (i.e. not for structural reasons).

On the latter point, the Fed’s estimate of NAIRU sits at 5.3%. Therefore, with a current unemployment rate of 6.1%, there is still a sizeable gap before the economy hits full employment and sustainable wage inflation takes hold. The Fed is unlikely to feel much pressure to warn of premature rate normalization, but the steady decline in the unemployment rate nonetheless serves as a reminder that the ZIRP era is coming to an end. Stay tuned.

Update On Gold

Gold prices remain trendless.

Update On Gold

Our Commodity strategists expect to maintain an underweight precious metals position within the commodity complex. The above chart shows that the key drivers of gold since 2008 – real interest rates, the dollar and investor risk aversion, proxied by the U.S. equity risk premium – have stabilized. Our view is that these drivers will remain trendless in 2014H2, although an equity correction could cause an intermediate-term shift. However, ETF volumes already have adjusted downward, minimizing any downside for gold (and silver).

What could make us wrong and begin a gold bull market? Ironically, a growth scare rather than an inflation scare is the most likely candidate. It would put pressure on central banks to boost liquidity “at any cost”, just like in 2008-2011. But we view that probability as unlikely.

Bottom Line: Gold will ebb and flow with the dollar against a flat trend.

A U.S. Recession Is Unlikely

The annualized 2.9% contraction in first quarter U.S. GDP was among the worst of the postwar era and the only one of its size that did not occur during a recession. But coincident and leading indicators suggest that a recession is highly unlikely.

A US Recession Is Unlikely

From the coincident perspective, the pickup in the pace of hiring, modest as it has been, contrasts with the deceleration of payroll gains that have regularly preceded recessions. Year-over-year movement in the leading economic indicator has been a solid recession predictor, and it is nowhere near contraction territory now. Stocks agree, as they typically begin to lose ground in the latter stages of expansions, and there has been no sign of the overheating in cyclical segments that typically precedes recessions.

Looking through three-month-old GDP data from the first quarter would therefore seem to be the right investment approach.

The silver lining for investors is that soft growth will preserve accommodative policy settings. As long as recession is avoided, any pullback in stock prices should be viewed as a correction, not the end of the bull market.

The BoE Turns Hawkish?

Hawkish comments from BoE Governor Carney gave sterling a boost late last week. However, the BoE will use macro-prudential policies to cool the housing market before resorting to interest rate hikes.

The BoE Turns Hawkish

At his annual Mansion House speech, Chancellor Osborne pledged to give the BoE greater powers to regulate mortgage lending in order to remove the froth from the housing market. This would entail setting limits on loan-to-value and loan-to-income ratios to discourage excessive borrowing.

Despite being given new policy levers, BoE Governor Carney also warned that he could raise rates sooner than the markets currently expect (which was April 2015). Not surprisingly, sterling reacted positively to Carney’s comments.

Our FX strategists think it is premature to conclude that a BoE tightening cycle is imminent. While the housing market is hot, the economic recovery in the U.K. is unbalanced and inflationary pressures are muted. For example, the trade deficit is at record levels and industrial production, while up from the lows, remains 12% below the pre-crisis peak. Meanwhile, CPI inflation is back below the BoE’s 2% target and wages ex-bonuses are rising by just 0.9% yoy.

Bottom Line: The BoE will use macro-prudential policies to cool the housing market before resorting to interest rate hikes. Our F/X strategists recommend staying out of the sterling market for now.