CONCLUSION: We continue to flag what we view as heightened risk for a JGB market rout; for now, however, the coast remains clear.


POSITION: Short the Japanese yen (FXY).


In the wee hours of the morning (US time) the international ratings agency Fitch downgraded Japan’s long-term local-currency sovereign debt rating one notch to A+; additionally, the agency reduced the country’s long-term foreign currency debt rating two notches to the same level. This action is critical in nature because we are now one step (i.e. a downgrade from another “Big 3” agency: S&P = AA- w/ NEG outlook and Moody’s = Aa3 w/ STABLE outlook) closer to triggering a ~$78B capital shortfall across the Japanese financial system.




One catalyst we see in accelerating the time frame of additional downgrades is that Japanese bureaucrats may wait until scheduled Upper House elections in the summer of 2013 to hold elections in the Lower House, per Azuma Koshiishi, secretary-general of the DPJ. Unless the LDP has backed off of their demand to dissolve the Diet prior to negotiating on the VAT hike, there will be no progress made on this front for over one full year – a major catalyst for further downgrades of Japanese sovereign debt further per commentary out of both of the remaining agencies.


The most recent downgrade (today) had a fair impact on the currency market, with the USD/JPY cross jumping from ¥79.58 to as high as ¥79.77 within minutes following the downgrade.




Looking to the Japanese sovereign debt market – which has been a key focus of ours this year as it relates to potentially being the next domino in the context of our Sovereign Debt Dichotomy theme – prices are not confirming Fitch’s worry that “[t]he country’s fiscal consolidation plan looks leisurely relative even to other fiscally-challenged high-income countries, and implementation is subject to political risk.”


Two, ten and thirty-year nominal JGB yields have trended down in recent months to ~7, ~9 and ~2 year lows, respectively. From a market demand perspective, a couple of recent developments highlight the [arguably] well-deserved complacency within that market in that the BOJ failed to receive enough offers from financial institutions for its recent Asset Purchase Program open market operation (only ¥480.5B of a ¥600B target); this is in addition to failing to meet a ¥310B target (¥174.7B offered) for its Rinban operation (purchases of JGBs w/ a maturity < 1yr). For now, Japanese financial institutions can’t get their hands on enough JGBs!




Given the impressive demand conditions, it’s no surprise to see that L/T-S/T nominal JGB yield spreads have compressed meaningfully over that same duration. Part of this is due to the risk that the BOJ decides on implementing further easing measures in its monetary policy meeting, which is currently underway (results published tomorrow). Increasing the [bond] duration of their purchases and potentially acquiring foreign assets are two policy initiatives we think they may pursue if they do decide to incrementally ease at the current juncture.




For context, we’re of the view that the Cabinet Office’s recently upgraded 2012 economic outlook and the central bank’s increasingly hawkish fiscal 2012-13 inflation guidance limits the need for them to pursue further easing measures in the near term; a chart of medium term breakeven inflation expectations in Japan confirm our view. On the flip side, the threat of rolling blackouts this summer ranging from 7-20% of peak consumption (depending on region) could force downward pressure on the Japanese economy over the intermediate term and force the central bank to react preemptively to maintain Japanese Real GDP growth, which, after four consecutive quarters of YoY contraction, accelerated to +2.7% YoY in 1Q12.




Jumping back to JGB risk, Japanese sovereign credit default swaps of the 5yr and 10yr tenors have backed up a fair amount in recent weeks, widening +18bps and +31bps, respectively, from their YTD lows. As the table below highlights, however, the widening seen in Japanese swaps recently has dramatically lagged the region, lending credence to our view that Japanese sovereign debt risk on this metric is merely accelerating as a function of global financial market contagion borne largely out of Europe. The same can be said regarding the recent widening of Japanese bank CDS as well, though perhaps to a lesser degree, given their outsized exposure to JGB risk (25% of total assets).








All told, we continue to flag what we view as heightened risk for a JGB market rout – particularly from current prices. That said, however, our call has not and will not invoke the consensus storytelling that simply focuses on highlighting the unsustainable nature of Japanese fiscal imbalances; rather we will continue to stay finely in tune with any/all catalysts that we find material enough to potentially shift sentiment within this market. For now, the coast remains clear and we remain bearish on the JPY vs. the USD from a long-term TAIL perspective – of course trading it with a bearish bias over the intermediate term, given its preponderance to appreciate in the context of our TREND-duration fundamental Global Macro view.


Darius Dale

Senior Analyst






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Keith shorted CSH in the virtual portfolio earlier today at $43.85. His quantitative levels show a TRADE (short-term) and TREND (intermediate term) levels of resistance at $44.61 and $45.97, respectively.


Our bearish view on CSH is growing. There are several factors at play here. 


* The YoY price change in gold is poised to roll from a 22% tailwind to an 8% tailwind in 2Q12 and if gold holds at its current level it will be a 7% headwind in 3Q12. A rough heuristic for the revenue model of a pawn store operator is that gold appreciation over the past decade has contributed 9.6%, or just over half, of the overall growth in revenue. We show this in the chart below. For CSH the effect should be more acute, because they hedge out the price of gold six months in advance. This means that when they reported 1Q12 results, they were actually reflecting the 38% 3Q11 YoY tailwind, meaning that gold price tailwinds will slow meaningfully for them for the coming 9 months.




* Judging from the divergence between expectations and reality, the consensus doesn't understand the amount of headwind the company if facing. Consider the net revenue growth expectations the Street is modeling in for the next 3 quarters relative to the headwind from gold.


CSH: A GOOD SHORT FOR THE REST OF 2012 - CSH expectations

Source: Factset Estimates, Hedgeye Research 



* The other issue at play here is whether gold volumes are drying up for the pawn operators. We wrote a note on this following EZPW's earnings, but to summarize: both FCFS and EZPW spoke to materially declining gold volumes, and EZPW attributed it to their borrower base running out of gold. Cash America came out and denied that they were seeing the same trends in their business, but call us skeptical. The main driver of the falling volumes is the emergence in the last few years of the pop-up gold buyer - ads for these places are now ubiquitous: billboards, radio, tv. These shops are taking share from traditional pawn business like CSH, EZPW and FCFS. A secondary factor is that the borrower base is running out of gold. The rise in the price of gold over the past decade has made for a largely one-way trade: gold leaves the population of pawn borrowers and returns, via scrap, to more affluent customers outside the pawn borrower population.




CSH: A GOOD SHORT FOR THE REST OF 2012 - Gold Macro Chart


CSH: A GOOD SHORT FOR THE REST OF 2012 - Rev by risk type


Joshua Steiner, CFA


Allison Kaptur


Robert Belsky


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Treasuries Will Eventually Revert To The Mean . . . But When?

Conclusion:  We covered our mean reversion short position in long term treasuries via the etf TLT yesterday as there are number of catalysts that will keep long term yields from increasing meaningfully through the end of June.  Beyond that time frame, much of fixed income looks like it could be short (at a time and price).


Earlier today, we covered our short position in the etf TLT, which represents long term treasuries with a 20+ year duration.  A key insight for us to enter this position was 10-year treasuries yields hitting basically an all-time low earlier last week at 1.70%.  The chart below shows the long term range of the 10-year over the past decade.  Currently, the yield of the ten year is 1.79%.  This is more than two standard deviations below average yield of the last ten years of 3.8%.  


Treasuries Will Eventually Revert To The Mean . . . But When? - 10yr.avg


Over the longer duration, the risk reward set up remains asymmetric for yields to increase.  We can see this in our price ranges as the TRADE range is tight at 1.66% - 1.81%.  Meanwhile, the TREND resistance level is 2.03%.  So, up to our intermediate term support levels there remains significant upside in yields and downside in bond prices.


In the intermediate term, despite the massive longer term reversion to the mean potential, it is unlikely to be a money making opportunity being short U.S. treasuries for two key reasons:

  1. Operation Twist – The Federal Reserve’s operation twist is scheduled to continue through June 30th. By some estimates, the Federal Reserve has already surpassed their target of extending average maturities by 100 months, but regardless they will keep buying longer dated treasuries for the next forty days and this will keep yield increases muted.
  2. Europe – As highlighted in the chart below that compares 10-year yields of Germany versus Italy and Spain, the European debt debacle is far from resolved and will continue to support the relative safety (albeit very relative) of U.S. government debt.   As our colleague Josh Steiner highlighted in a note yesterday on Greek elections, the looming June 17th election in Greece will have critical impact on the future of austerity and reform in Europe, and as a derivative the yields of European sovereign debt.  If there is risk in European sovereign debt, U.S. treasuries will remain a safe haven of sorts.  

Treasuries Will Eventually Revert To The Mean . . . But When? - 10yr.euro


Longer term, the increasingly key consideration will be the U.S. fiscal and balance sheet situations, which continues to deteriorate in the year-to-date.  For starters, the Congressional Budget Office raised their estimate for the deficit in fiscal 2012 by $93 billion to $1.2 trillion in March.  This key reason for this is because revenue has basically been flat year-over-year.  As a result federal debt-to-GDP is hovering just over the 100% mark.


The key negative fiscal catalyst for Treasuries beyond June 30thand the end of Operation Twist is the debt ceiling getting hit again and the potential for another downgrade of U.S. sovereign debt (The caveat is that the last downgrade did not lead to an increase in yields.) The current debt ceiling is $16.4 trillion and the public debt balance as of May 18this $15.7 trillion.  Interestingly, roughly seven months ago the public debt balance was $15.0 trillion, which at a similar rate of growth suggest we should hit the debt ceiling by the end of calendar 2012.  Once again, this will be major political football that will increase consternation related to low historical yields.


One last point we wanted to highlight in this note was that of relative yields.  In the table and chart below, we compare U.S. investment grade yields to U.S. junk bond yields to the earnings yield of the Dow Jones Industrial Index to the yields of 10-year treasuries.  Not surprisingly, given the bubble in treasuries, there is a relative bubble of sorts in the rest of fixed income. 


Treasuries Will Eventually Revert To The Mean . . . But When? - 3



Specifically, both investment grade bonds and junk bonds are trading well below their long run average yields and at, relatively, tight spreads to treasuries despite the artificially low yields in the treasury market.  Trailing twelve month earnings yields for the Dow Jones Industrial Index appear relatively cheap, but, as always, equity valuations depend on the future view of growth.  Interestingly, historically the earnings yield spread between the DJII and 10-year treasuries has actually been meaningfully tighter than between junk bonds and 10-year treasuries.   This implies high yield could be most at risk in a mean reversion scenario or if economic growth slows more dramatically.


Treasuries Will Eventually Revert To The Mean . . . But When? - 4


Clearly, Japanese sovereign debt yields have stayed low despite major growth and fiscal headwinds.  The same scenario may well play out in the U.S., or, as they say, this time could be different and reversion to the mean in the fixed income market could catch many off guard. As Hemmingway famously wrote:


“It occurs very slowly, then all at once.”




Daryl G. Jones

Director of Research

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