29 January 2024 - Thoughts on the Market

In my write-up last week, I noted that I had just put on a basket of short currencies against the Japanese yen and the Swiss franc. Specifically, I sold euros, British pounds, US dollars, and Canadian dollars against the yen and franc. The trades have not been particularly exciting, but they are working. The short US dollars, short euros, and short pounds have been the best performers so far, but even the Canadian dollar is showing some weakness on the crosses.

Today is a bit unusual since it has been one of the few days this year when the New York market has actually been pushing dollar yen lower. This will be a busy week in terms of “risk” events, and that will likely continue to support the yen.

As my readers know, for some time now the Japanese yen has been a beneficiary in times of serious levels of market risk. Extreme levels of systemic risk have often led to dramatic surges in the value of the yen, while more modest degrees of risk have generally led to more tame periods of yen strengthening. This week the market will have a lot to digest, with non-farm payrolls, unemployment news, Michigan Consumer Confidence Sentiment, ISM Manufacturing, a Bank of England interest rate decision, and the Fed interest rate decision. Although I don’t expect any movement on interest rates for some time, we might glean some hints about both future Bank of England policy and future Fed policy, with the Fed’s conference being particularly important. Market players will be listening carefully during the conference in hopes of receiving some hints about the timing and pace of future interest rate cuts.

Recent data confirms that the US is on its way towards achieving its stated 2% annual inflation target. Inflation data has been trending in the right direction, and although further progress is required, the overall path seems clear for the time being. Yes, the next significant drop in inflation might take some time, but rates in the U.S. will be dropping later this year. Therefore, the Fed’s words will be the most important risk event for the currencies, as we can’t rule out any surprises regarding the possible timing.

Dollar yen is particularly sensitive to interest rate developments as tens of billions of dollars of short yen exposure have been built up on the back of the interest rate differential between the U.S. and Japan. Even a strong hint of that differential changing can lead to some dramatic position adjustments. Unlike the typical situation, once the trajectory of that differential is clearly on a downward path, the market will not just sell the “rumor” and the clear expectation of a narrowing in the differential, but they will continue to buy yen once the fact of the narrowing differential is underway. In other words, the market will sell the rumor and sell the news once the Fed more formally confirms that lower interest rates are definitely coming in the relatively near term. Investors will start unwinding some of their massive carry plays, and as they start buying yen and selling dollars, euros, pounds, and Canadian dollars, stop losses will get triggered by shorter term players. This will in turn lead to still further unwinding of carry plays, and this unwinding will accelerate once the convergence in rates is underway.

There are two components to this unwind, and the movement of rates in the U.S. is only half of the story. The other half of the story is the situation in Japan, and my bet is that the Bank of Japan is inching ever closer to shifting its negative interest rate policy towards a more sensible positive interest rate stance. The thirty-four-year deflationary cycle in Japan is nearing its end, and the dollar’s strength against the yen will likely end with that policy shift.

In 1990, dollar yen traded around 160.16, and after cascading all the way down to 76.00 yen per dollar, the dollar looks like it has failed to sustain levels above 150.00 despite the massive interest rate differential in favor of the dollar. The Bank of Japan is focused on wage growth as the critical determinant in its policy making, and it now feels that sustained wage increases above two percent per annum seem to be well established. The more volatile measures of food and energy gave the Bank of Japan a bit of comfort recently, but oil has rallied a full ten percent in the past week alone. In the next four to six months, we might very well have the simultaneous dropping of rates in the U.S. while rates in Japan are inching higher.

There are other things happening in Japan which will certainly have an impact on the Bank of Japan. The Nikkei has recently touched its highest levels since 1990. There is a mood of optimism that was largely absent during the past thirty-four years, and this will have positive knock-on effects on the economy. The Japanese investors, despite the massive deflationary cycle, are still very wealthy, and the economy is still very large. We should not underestimate the financial power of Japan and its investors.

The government’s debt level is massive (over 230% GDP), but the economy has somehow weathered a ferocious storm. Germany may pass Japan as the world’s third largest economy, but I wouldn’t be surprised to see Japan retake the 3rd slot in the ranking. The economy is diversified, and Japan runs a large current account surplus. This should help the country slowly reduce its massive government debt levels. In any event, we need to start looking at Japan once again as a global economic super-power with very strong financial resources. The people there are hardworking and disciplined, and we should not bet against them.

Regarding more volatile measures of inflation, I wrote previously that I feel that oil is trying to put in a significant low, and I stick with that view. There is very solid support in the mid-to-high $60’s, with $67.00 per barrel being a very obvious level of significant support. There is likewise obvious short-term resistance between $80.00 and $82.00. It is certainly reasonable to expect a move back up toward $90.00 per barrel, and perhaps $95.00 per barrel, but it is still early in the process. If we can clear $95.00 per barrel, then we could be starting a huge swing back to the highs of 2022 in the high $120’s.

For me, the particular relevance of oil is the impact this might have on central bank policy making. Unlike gold, which I love to trade, I typically don’t trade oil nearly as much. Rather, I watch the oil market in order to get insights into other markets. Currently, the inflationary aspect of oil is of particular importance to central bank policies, so we should all pay close attention to the action in this market. Put simply, a sustained surge higher in oil, coupled with further evidence of wage increases of at least 2% per annum, will almost undoubtedly push the Bank of Japan to move on rates. The knock-on effect in the currencies will be significant.

One of the fascinating aspects of trading is to watch the herd-like mentality of market participants. Towards the end of 2021, investors were giddy with excitement. They couldn’t buy stocks fast enough. In March of 2022, the Fed started hiking rates, and by the end of the year, investors were in full panic mode. They had no interest in buying stocks at that time. Now that we are close to the end of the Fed’s tightening cycle, investors are again thrilled to be pouring money into the stock market. Interest rates are a full 5% higher than they were at the end of 2021, yet stocks have made new all-time highs.

Yes, interest rates are likely to come down at least 100 basis points by the end of 2024, but is that a reason to continue to plow into the equity market at all-time highs? What people are forgetting is that there is a twelve-to-eighteen-month lag before the full impact of interest rate hikes works its way through the economy. Will the highly anticipated reduction in interest rates really lead to a surge in earnings and economic performance that will support another giant leg higher in stocks? That idea is certainly being touted by quite a few pandits right now. Many of these same pandits were bearish on stocks at the beginning of 2023.

As a trader, I don’t mind jumping on a trend that doesn’t make fundamental sense to me, but I am certainly going to be cautious about expecting stocks to continue surging higher without a nasty sell-off from slightly higher levels. It would be a classic set-up if the market were to break hard after making a new all-time high that was unsustainable.

So what is fueling the economic growth right now? In a way, it is simple. The Fed’s balance sheet is about $6 trillion bigger than it was in 2001, and federal deficits have absolutely exploded during this same time period. The growth we are experiencing is real, but it is based on a great deal of debt and leveraged assets. At what level does this scenario become unsustainable? That is a topic for a future write-up. The irrefutable fact, however, is that we are moving into very dangerous levels of leverage and debt.

In terms of recent market movement, Yellen just announced that Treasury borrowing requirements for the second quarter have come in way below market expectations. Yields are dropping sharply, as is the dollar. Whether this estimate proves to be accurate remains to be seen since the Treasury has borrowed $134 billion in the past four weeks, but now claims that they will only need to borrow $202 billion for the entire second quarter. They have also reduced their expected borrowed costs for the current quarter by some $55 billion. Let’s see how this plays out. It is certainly constructive news. Regardless, the interest due on federal debt will top $1 trillion this year. That certainly seems like a big number to me.

In any event, there are other serious structural problems and challenges in the economy right now. Housing unaffordability is at an all-time high, commercial vacancy rates are at dangerous levels, massive refinancings for commercial properties are required in the next twelve to eighteen months, and over 90% of all US residential mortgage holders have mortgages with fixed rates under 6% interest. This last fact is important because current homeowners don’t want to sell their homes unless they can organize comparably attractive financing rates, and that won’t be possible for quite some time. Therefore, we have reduced inventory of houses for resale, and reduced inventory will keep housing prices elevated, so we are stuck in a bit of a vicious circle. Bottom line, there are many structural issues facing us over the next year that suggest Wall Street and Main Street are not reflective of one another. We will address these issues in coming writeups as they will all have an impact on multiple markets. They are a bit complicated, however, and their impact can affect markets in multiple ways.

In the meanwhile, I wish you the best of luck in the markets.

Andy Krieger