Financial markets continue to signal that global growth is weakening and deflationary pressures are building.
T he global stock-to-bond total return ratio is still heading lower, indicating slowing world growth. More worryingly, the bond-to-gold total return ratio has broken above its 200-day moving average for the first time since 2008. The absence of a spike in the bond-to-gold total return ratio, until recently, was a sign that the markets felt major central banks would act in a timely manner to avert deflation.
The current signal from the indicator is that no such confidence exists today. If the “risk off” climate persists, the U.S. dollar could strengthen further in the short term. However, our Foreign Exchange Strategy service argues against building fresh long positions as the dollar is already technically overbought. Our capitulation index and intermediate-term momentum indicator are both at elevated levels.
Long positions in the Japanese yen offer the best defense in current market conditions.
During periods of severe risk aversion, the yen even outperforms the dollar. Investors should maintain a core short USD/JPY position. This also means that rather than short EUR/USD, short EUR/JPY is a better way to play euro weakness amid the ongoing debt crisis.
Any policy response from the Bank of Japan (BoJ) is likely to be muted in comparison to the Fed or ECB. The BoJ’s balance sheet has significantly lagged those of the Fed and ECB since the global financial crisis of 2008. We doubt that this will change, so relative monetary policies should remain bearish for USD/JPY and EUR/JPY.
Bottom line: Until policymakers take appropriate steps to stem downside risks to the word economy, long positions in the Japanese yen will offer investors the best defense.