Update On The Yen

Japan’s balance of payments is worsening, but this alone is not enough to change our bullish stance on the yen.

Update On The Yen

I n the twelve months to August, the Japanese current account surplus remained close to a 15-year low, net portfolio investments turned negative for the first time since May 2011 and net foreign direct investment outflows were near a record high. However, this is not necessarily negative for the yen against the dollar.

Japan’s basic balance (current account plus long term capital flows) deficit of 1.6% of GDP is only half the size of the U.S. In addition, net portfolio flows to Japan should improve. Japanese investors will be reluctant to recycle their excess savings into overseas assets as interest rate differentials between the U.S. and Japan are negligible.

Historically, Japanese investors have required a minimum 400bps of additional yield as compensation for assuming currency risk. With the Fed committed to holding rates near zero until mid-2015, interest rate differentials will remain bearish for USD/JPY for quite some time. Also, the BoJ will be less aggressive than the Fed and ECB in expanding its balance sheet, which will push USD/JPY and EUR/JPY lower. But most importantly, the yen will provide portfolio protection during “risk off” periods.

Bottom line: Maintain long positions in the Japanese yen.

Agency Mortgage REITs: Time To Bail

The risk/reward of owning Agency Mortgage REITs has deteriorated.

The risk/reward of owning Agency Mortgage REITs has deteriorated.

O ur U.S. Investment Strategy service recommended buying Agency Mortgage REITs (MREITs) in June 2011. Since then, MREITS have outperformed the S&P by more than 5 percentage points. However, this trade has lost its appeal as Agency MBS prices have recently appreciated significantly.

This move has caused the spread between the REITs’ portfolio yield and their funding costs, which have not moved, to tighten dramatically, placing acute pressure on net income. Continued dividend cuts are inevitable unless the REITs further boost leverage to maintain returns on equity, while returns on assets slide.

Leverage is at the heart of the agency MREIT model but we do not like the risk/reward profile of borrowing more to purchase agency MBS at prices that may well mark an all-time top. It is typically monetary tightening that lowers the curtain on agency MREIT cycles, but this time around the Fed is killing the group with its kindness.

Bottom line: Our U.S. team recommends closing the MREITs trade.

Euro Area: Tail Risk Down, Economic Risk Up

European tail risks have clearly diminished, though this has had the perverse effect of deteriorating credit conditions for the euro area as a whole.

Euro Credit Risk vs. Economic Risk

A fter a sharp fall earlier this year, our measure of global credit impulse has troughed in the last few months. This suggests that economic activity should stabilize in the fourth quarter. But after recent strong rallies, risk assets seem to be well-priced for this stabilization and then a resumption of growth in early 2013.

That may be too optimistic.

True, the reduction of tail-risk in Europe is very welcome, but it has come at a price. It has perversely pushed up long-dated bond yields in the core economies as safe-haven flows have reversed. The upshot is that the all-important weighted average yield across the euro area has increased. Therefore, somewhat paradoxically, credit conditions for the euro area as a whole have actually deteriorated.

As we recently highlighted, with Europe now facing a double-dip recession, policymakers will likely need to do more, regardless of tail risks.

Bottom line: Only a benchmark cyclical weighting in European risk assets is warranted.

U.S. Equities: The Liquidity/Growth Tug-Of-War

While central banks can fuel meaningful short-term asset price rallies, sustaining the gains eventually requires evidence that extra liquidity is providing a lift to economic growth and profits.

U.S. Equities- The Liquidity:Growth Tug-Of-War

S urvey evidence and equity sector relative performance suggest a high degree of skepticism among investors that QE will translate into economic growth.

Cyclical sectors led the stock market higher after the QE1, QE2 and “Operation Twist” announcements. In contrast, defensive sectors have outperformed since the latest QE announcement. Global growth appeared to be on the upswing around the time of QE1 and QE2. Today, the U.S. economy is approaching stall speed, Europe’s recession is deepening, and the near-term outlook for the rest of the world remains soggy.

Moreover, the S&P 500 index shot up 12% before the Fed’s latest policy announcement and is technically overbought. The forward P/E ratio has reached 13 times, significantly higher than when QE1 (12.3) and QE2 (12.6) were announced. Finally, the near-term outlook for corporate earnings is far less optimistic than it was during the previous two rounds of QE.

The bottom line is that we would expect another upleg in risk assets if the ECB and the PBoC were to join the Fed in providing another global liquidity injection. However, the clock is ticking because the fiscal cliff is approaching, and profits and economic growth indicators are not providing support.

For now, we remain constructive on pro-cyclical investments, though expect a consolidation phase ahead of the fiscal cliff.


With momentum indicators near extremes, there is a good opportunity to short EUR/GBP.

With momentum indicators near extremes, there is a good opportunity to short EUR/GBP.

S terling is benefiting as global investors look for alternatives to the two major currencies, the dollar and especially the euro. With the SNB effectively pegging the Swiss franc to the euro and given the limited liquidity in the Swedish and Norwegian crowns, investors have been turning to sterling.

This trend should continue.

Despite the widening current account deficit, the U.K.’s basic balance is improving rapidly due to a swing in long-term capital inflows. The technical picture for EUR/GBP has improved significantly. The cross retraced to its 200-day moving average, which held as a key resistance level. Also, the deeply oversold conditions from this summer have been worked off. In fact, EUR/GBP is now becoming overbought. This is bearish from a contrarian perspective. Finally, EUR/GBP is still overvalued: our PPP model suggests that another 10% of downside is easily possible.

For these reasons, our Foreign Exchange Strategy service recommends a short EUR/GBP position.