This note was originally published November 27, 2013 at 22:20 in Macro. For more information on Hedgeye research and how you can become a subscriber click here.
- Tactically speaking, we think investors should book gains, underweight or aggressively hedge the Abenomics Trade (i.e. short JPY/long Japanese equities) here, as the risk/reward setup is overwhelmingly poor with respect to our intermediate-term TREND duration.
- There are three key reasons for doing so:
- The Fed will likely dominate headlines with surprising levels of dovish monetary policy amid a 3-6M monetary and fiscal policy vacuum in Japan.
- Sentiment towards Japanese equities amongst foreign speculators has reached euphoric levels.
- Speculators have recently adopted an overwhelmingly bearish position on the yen. Historically, the USD/JPY cross has faded hard from such asymmetric setups in the futures and options market. Moreover, what’s bullish for the yen has been almost perfectly bearish for Japanese stocks.
You ever host friends over at your place and call it a night when everyone leaves to go to the bar, only to find out the next day that you missed an epic night out on the town?
Okay, we’re guessing that hasn’t happened to you all that many times, but that’s certainly how we feel right now with regards to the “party” that is the Abenomics Trade. Specifically, we suspended our bearish bias on the Japanese yen and bullish bias on the Japanese equity market back on OCT 4 in a research note titled, “REMOVING FXY SHORT FROM OUR BEST IDEAS LIST”.
In retrospect, that was a rather poor call to make: the USD has appreciated +4.8% vs. the JPY since then and the Nikkei 225 Index is up +10.2% over that same duration.
Rather than whine about not nailing the last ~5% of a +31.6% move in the USD/JPY cross since we authored the bearish thesis back in SEP ’12 or griping about not being along for the last ~10% of a +76.4% ride in the Nikkei 225 since we started explicitly calling for Japanese equity reflation back in NOV ’12, we prefer to focus on the task at hand that is risk managing the next big move – be that up or down.
Continuing on along that line of reasoning, we are increasingly of the view that the risk/reward setup of being overly exposed to the Abenomics Trade at the current juncture is quite poor.
Specifically, we think US monetary policy is setup to surprise consensus to the dovish side over the intermediate term, while a monetary and fiscal policy vacuum in Japan leaves investors well shy of the types of major catalysts needed to propel an already-crowded trade further.
To review the detailed analysis supporting the former of those points, please refer to the following two research notes: “EARLY LOOK: TOUGH QUESTIONS” (NOV 22) and “GOLD: IS IT TIME TO GET BACK IN ON THE LONG SIDE?” (NOV 26).
Regarding the latter point, we continue to believe that over the next 3-6M, neither the BoJ nor the Diet will implement any of the types of dramatic monetary easing or groundbreaking fiscal policy reforms that we were outlining as compelling catalysts around this time last year.
The latest on this front was the OCT 31 BoJ meeting and its subsequently-released minutes, which: A) were as uneventful as the previous seven BoJ meetings; and B) all but explicitly reiterated what Kuroda has gone on record with before: there will be no preemptive easing to cushion the blow from the FY14 consumption tax hike. If anything, the next time the BoJ eases will be sometime in the late spring of 2014 after Japanese growth is likely to have slowed for 2-3 consecutive quarters, according to our GIP model.
The next major fiscal policy catalyst was supposed to be DEC 14, when the current 53-day special Diet session ends. Purportedly, there will be some fairly meaningful economic reforms announced, but we’re now happy to take the other side of that speculation. This is supported by Abe’s recent decision to punt the announcement of the second round of his growth strategy to JUN ‘14. As such, we now think that’s when the most impactful of economic reforms will be introduced, thus increasing the likelihood that anything announced this DEC will be perceived by market participants as a disappointment.
Considering that all of this is likely to happen amid a fresh round of USD debauchery out of the Federal Reserve increases the likelihood that market participants will feel the pinch of Japan’s monetary and fiscal policy vacuum between now and next spring.
As opposed to being an explicit GIP catalyst, the next two reasons why you should tactically fade the Abenomics Trade for next few months are sentiment-oriented.
The least important of the two is the almost euphoric piling into of Japanese stocks by foreign investors amid net domestic divestment from the equity market. In the YTD, foreigners have purchased a net ¥13-plus trillion of Japanese shares – the highest total on record. This contrasts with a net ¥6T of net sales amongst Japanese institutional investors.
Moreover, the aforementioned foreign/domestic bifurcation has intensified in recent weeks. The most recent weekly data shows a net purchase of ¥1.3T by foreign investors, which represents a 7M-high. Conversely, net sales of domestic assets by Japanese retail inventors hit ¥174B last week – the largest weekly divestment since 2008. The doubling of the tax rate on capital gains and dividends to 20% at the start of next year was widely cited for the acceleration in equity sales.
Lastly, a Nikkei/Veritas survey of investment professionals released today calls for a median +16% gain in the Nikkei 225 Index by JUN ’14. The key takeaway here is that sentiment among Japanese equity investors – the most active of which have been predominantly foreign [buyers] throughout the YTD – is overwhelmingly bullish.
Our third and final reason for tactically fading the Abenomics trade is more oriented towards global macro sentiment. Specifically, just about every living, breathing soul with the ability to speculate in FX markets is short the Japanese yen here. While that in and of itself is not a catalyst for price declines, it does highlight just how risky it is to be adding to positions up here around ~102 on the dollar-yen rate – especially considering that the cross has yet to make a higher-high in the current cycle (vs. its MAY 17 intraday high of 103.74).
Adding some more meat that bone, the latest reading in non-commercial net length of 110,309 futures and options contracts to the bearish side (i.e. net short) represents a -2.7x standard deviation delta from the TTM average. Contrast that reading with a 21,908 net long position in the aggregated JPY futures and options markets back in SEP ’12 when we authored the bearish thesis on the Japanese yen.
Additionally, the current net length reading is the most bearish speculators have been on the JPY since mid-2007. Anyone who was transacting in these markets then knows just how caught off-sides consensus was at that time; the USD/JPY cross dropped ~37 handles from its JUN ’07 high of 123.89 to its 2008 trough of 87.24.
Obviously, the setup is not the same here, given that Kuroda & Co. will likely step in well before the currency markets get out of hand. That said, however, having to trust a central planner to protect your P&L when the market is this so asymmetrically skewed in one direction is a risky position to be in. Who knows what’ll happen in 2014? We sure don’t…
Going back to the -2.7x standard deviation point we made earlier, we decided to compile a table highlighting what has happened historically when the crowd gets so overwhelmingly bearish on the Japanese yen. Looking at the past ten years of CFTC data, we see that the USD has tended to decline -5.2% vs. the JPY, on average, over an average period of 15.3 weeks, after speculator sentiment has swung so resoundingly bearish on the Japanese yen. The one outlier in the dataset is last DEC’s -2.2x reading ahead of the telegraphed regime change at the BoJ, so that should provide some solace for Johnny-come-lately yen bears (think: “this time is different”).
Living dangerously, if we extrapolate that -5.2% average delta to current prices, that gets us to an implied level 96.72 on the USD/JPY cross. Assuming longstanding cross-asset correlations hold (fluctuations in the USD/JPY cross have explained 94.1% of the fluctuations in the Nikkei 225 Index over the past 3Y), that would portend a -13.7% correction in the Japanese equity market over the next 1-2 quarters.
A correction in the USD/JPY cross to our intermediate term-TREND line of support at 99.26 would suggest a milder -9.7% correction in the Nikkei 225 Index, while a drop to our long-term TAIL line of support at 93.68 on the USD/JPY cross would imply a more serious draw-down of -18.5% in the Japanese stock market.
From either of those points we’d strongly consider reallocating assets to the Abenomics Trade – hopefully just in time for the BoJ and the Diet to deliver what the market is obviously praying they deliver at the current juncture. Remember, we’re still very bearish on the yen with respect to the long-term TAIL; we’re merely just trying to help you manage what we perceive to be a pervasive level of duration mismatch.
I know it sounds like we’re trying to thread the needle here and, to some extent, we are. We feel comfortable doing so only because we now hold a counter-consensus view of US monetary policy over the intermediate-term and are increasingly looking to exploit that view across the global macro landscape.
It’s worth noting that the last time we’ve held such a counter-consensus view on US monetary policy (we thought the Fed would be more hawkish than expected then), long-term interest rates backed up dramatically all over the world in just a few short months (over +100bps domestically). Review our MAY 22 note titled, “JAPAN ASKS: “ARE YOU PREPARED FOR A MEANINGFUL BACK-UP IN GLOBAL INTEREST RATES?”” for a summation of that call.
Same process; different conclusions...
Associate: Macro Team