MONTHLY Safe Haven Trades Are FX OUTLOOK Everywhere in … · the yen should be much weaker. While...

MONTHLYFX OUTLOOKJuly 2014

Safe Haven Trades AreEverywhere in G10 FX

| www.monexeurope.com

Financial Markets ResearchEimear Daly - Head of Market Analysis

ABOUT MONEX

MONEX MONTHLY FX OUTLOOK 08 JULY 2014 1 of 15

Monex Europe - Europe’s leading commercial foreignexchange specialist.

Based in the heart of the City of London, Monex Europeprovides confidential, same day spot and forwardforeign exchange contracts to a client base of FTSE-listed companies, large corporations, SMEs and financialinstitutions.

As a specialist foreign exchange company, our clientsbenefit from the highest quality of service, speed andflexibility. We couple this with the scale of a bank,which enables us to meet any FX need and constantlyexceed your expectations.

Monex Europe is the European arm of Monex Holding(also known as Monex Group), a global financialservices group headquartered in Mexico and operatingthroughout Latin America, the US and Europe.

As well as being one of the world’s largest commercialforeign exchange providers, Monex Group is also one ofthe most dynamic and fastest growing financial servicescompanies. Monex Group is listed on the Mexican stockexchange (BMV: MONEXB).

Monex Group is authorised to act in Mexico as a bank,broker dealer, mutual fund company and financialgroup; in the US as a broker dealer, investment advisorand money transmitter licensed to act in all states; andin the UK as a payment institution. The Group is afinancially regulated entity in all the countries in whichit operates.

EIMEARDALYHead of Market Analysis atEurope’s leadingcommercial foreignexchange broker,responsible for the tradingstrategy of over $125bn inFX turnover with a proventrack record of forecasting

accuracy. A familiar face to many as a regular onfinance TV including Bloomberg, CNBC and SkyNews and the go-to commentator for insight intothe G10 FX and money market space. Previouslypolled “fifth most accurate forecaster of G10 FX” byBloomberg, number three for euro-dollarforecasting and number seven for sterling-dollar.Appeared as FX Week’s number one forecaster forone month ahead and quarterly forecastingaccuracy.

RATINGS/AWARDS

FX Week’s Top 30 Forecasters

Ranked 2nd - One month ranking

FX Week’s Top 30 Forcasters

Ranked 3rd - 12 month ranking

Source: FX-Week as at 7th July 2014

Bloomberg Best Euro-Dollar Forecaster Q2 2014

Ranked 7th - Best Overall Forecasters

Bloomberg Best Sterling-Dollar Forecaster Q2 2014


Bloomberg Best Dollar-Swiss Franc Forecaster Q2 2014


Source: Bloomberg as at 30 June 2014

CONTENTS3 Introduction

4 Sterling

7 Euro

10 Japanese Yen

13 Realised Volatility

14 Market Positioning

15 Directory & Disclaimer



INTRODUCTIONIt’s time to debunk the myth that we are in a carry traderisk environment. Financial markets have shockedconsensus expectations as equity markets grind outnew record highs and volatility flat lines despiteongoing geopolitical concerns and the weaknessrevealed in specific emerging markets last year.However the equities bull market contrasts with asurging bond market. In fact the meagre gains that haveled to record highs in the S&P500 are a result ofcorporate share buy backs and company cost cutting.Equity market highs are not the result of globaleconomic optimism. We argue the same misleadingdynamics are at play in G10 FX and mask an underlyinghunt for safety.

The most obvious sign that all is not right in this “carrytrade” environment is the persistent strength of theSwiss franc and Japanese yen. USDCHF is down 7.2% onthe year, hinting at the undercurrent of safe havendemand. The currency pair, a relative fear gauge,entered a new lower trading range in February andMarch as Ukrainian tensions escalated.

The Japanese yen remains well supported and tradessideways against the US Dollar. It has decoupled fromits traditional drivers with yield differentials suggestingthe yen should be much weaker. While many put thecurrency’s stubborn strength down to markets pricingout BoJ easing, this explanation certainly isn’t reflectedin the JGB market.

Many proponents of the risk trade point to theoutperformance of AUD and CAD, the classic carrycurrencies, as signs the market has forgotten that theend of abundant global liquidity is nigh. AUD and CADhave defied clear signs of weakening fundamentals andbroken away from past correlations to commodities.

These are carry currencies but they are also triple A inan environment where emerging market central banksare hoarding reserves. In the IMF’s CurrencyComposition of Official FX Reserves, central banksreported a 22% increase in CAD holding, compared to a7% in overall reserve holdings. While AUD holdings wereonly up 6.15%, there are other dynamics at play forChina’s close neighbour and strong economic partner.Chinese investors are facing an overvalued propertymarket which is threatening to pop and a shadowbanking sector which may have already popped.Chinese capital is being funnelled into Australia. This ismost apparent in Australia’s booming housing market.According to RP data, there was $24.9billion of foreigninvestment into Australian property in the year toMarch, representing 13% of the total property sold.

Eurozone peripheral bond markets may even bebenefitting from safe haven flows. From the start of thisyear, a negative correlation with volatility broke downand peripheral debt began to gain on increased globalconcerns. There is also evidence that eurozoneperipheral debt is trading as an asset class as oppose toseparate markets.

When something doesn’t look right, it usually isn’t. Themarket isn’t as naive as to overlook the end of a 6 yeareasing cycle which has seen unprecedented centralbank easing or the risks of bubbles bursting as theChinese economy manoeuvres itself onto a slowergrowth path and opens up its capital account. Moneymanagers are bracing themselves for the end to excessliquidity but the new post financial crisis worldnecessitates a new strategy. The end of US QE and lesssupply of Treasuries means these assets and the dollarhave lost some appeal. Money managers have foundalternative safe havens that just so happen to offer areturn.

STERLING MacroeconomyThe UK economy picked up pace in the first quarter,and despite official forecasts looks in no danger ofslowing down. The UK economy rose 0.8% on the firstquarter, leaving the economy within a whisker of itspre-crisis level of output. Although the rate of growthwas just 0.1% faster than the fourth quarter, thebreakdown showed a positive evolution. Whileconsumption continued to show robust growth,business investment emerged as a significantcontributor to output. Not only does this hint at arebalancing in the UK economy, but suggests the UKrecovery is more sustainable. Business investment levelswere conspicuously low even before the 2008 crisis.Record low interest rates from 2008 had little to nosuccess in raising investment, likely the combination ofbanks cutting lending portfolios and businesses’aversion to taking on new debt. A more virtuous cyclethat is driven by investment has now begun in the UK.Although the UK’s recovery in economic growth wasinitially driven by debt-fuelled consumption, there isnow hope that economic rebalancing is happeningbeneath the surface, and thus growth looks moresustainable.

Discrepancies Suggest Something Isn’t Right In the UKLabour Market

Source: Bloomberg, as at 08/07/2014

Initial readings for the third quarter suggest the UKcontinued to grow at a rapid pace. The UK looks set toreclaim, if not exceed, its pre-crisis level of output. Inindustry terms, the services sector continues to poweractivity in the UK. The manufacturing and constructionsectors remain significantly smaller than before 2008but they have been growing rapidly for five consecutivequarters. Retail sales continue to grow backed by lowinterest rates and gaining consumer confidence. Themost significant development is that leading indicatorssuggest no slowdown in future activity. Officials hadforecast that the initial release of pent up demandfollowing the crisis would ease into 2014 and thatgrowth would slow with it. However, with order booksat multi-year highs, there is no slowdown in sight forthe UK economy.

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However, there are inconsistencies and serious riskswithin this recovery. A constant qualm for policymakers is the failure of UK productivity to recover. TheConference Board productivity index has risen only2.85% from its post financial crisis trough. Policymakersstruggle to explain why the UK seems to havepermanently lost some of its output potential. Whatthey do know is that it has real economic implicationsand they blame the failure of wages to recover to pre-crisis levels on the loss in productivity. Therein may liethe answer to the UK’s missing productivity. The UKlabour market has experienced a vibrant recovery. Sincethe beginning of 2013, the unemployment rate hasdropped 1.2 percentage points to 6.6%. Three month jobcreation has surged above 300K. Over the last 18months, self-employed positions accounted for 50% ofall job gains. Part-time jobs account for 20%. Theevidence suggests spare capacity is hidden in the UKlabour market and could be responsible for the UK’smissing productivity growth.

The UK’s much hyped export-led manufacturingrecovery never materialised. The UK’s continues to be anet debtor to the rest of the world with significantexternal imbalances. This presents a potential risk to theUK recovery as we continue to spend more than weearn.

The UK housing sector is both the most obvious andbiggest risk to the UK recovery. The government’s Helpto Buy scheme set a dangerous precedent for highloan-to-income mortgages and opened up thismortgage market in the UK. £375billion in quantitativeeasing buoyed general asset prices, but a globalreputation as a safe haven market perpetuated houseprice growth, especially in the London area. Householdlending secured on dwelling rose only 2.1% on the yearin April but nationwide house price growth inched intodouble digit figures, with particular gains in the SouthEast. The resurgence in mortgage lending saw a notableincrease in the loan-to-income ratio as weak averagewage growth undermined affordability. The proportionof LTI ratios above 4 rose 22% in Q1 2014, exceedingthe former peak in 2007. At the June FPC meeting,Governor Carney described current projections for thehousing sector as “the limit of our tolerance on thehousing market” and introduced recommendations of a15% cap on the number of LTI ratios above 4.5 and anofficial affordability test. The measures had little realbite. By Carney’s own reckoning, the 15% LTI cap won’taffect actually lending until a year out and doesn’taffect the central outlook for the economy. Themeasures’ biggest impact will be in the official messageit sends to international markets that UK authorities areconcerned about a housing bubble and are willing toact to address it.



STERLING Monetary PolicyWe make the unorthodox comparison between theBank of England and the 90’s movie Speed. Effectively,Governor Mark Carney must keep a city bus, the UKeconomy, running above a certain speed to prevent abomb from exploding. The bomb, in this case, is theburden of household indebtedness, a bubbling housingmarket, chronic external imbalances and a reliance onconsumption. A too rapid tightening of monetary policywould cause this bomb to detonate, revealing the factthat the UK economy has all the same defects as beforethe recession, as well as some new ones. Carney mustmaintain a certain momentum in economic growth toprevent this outcome, explaining the BoE’s commitmentto slow and gradual rate rises. Recent commentarycoming from the bank has patched together a roughtimeframe of interest rates hikes coming as soon as thisyear, with a terminal rate of around 2.5% around early2017.

Elevated Household Debt Leaves the UK Vulnerable


Governor Carney has been unfairly accused of policyinconsistency, with one MP even dubbing him an“unreliable boyfriend”. Carney’s Mansion House speech

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sent a jolt through financial markets as Carney warnedan interest rate rise may come “sooner than marketsexpect”, causing the short sterling market to price in 42basis point of hikes by December. June BoE minutesexpressed surprise by “the relatively low probabilityattached to a Bank Rate increase this year” but fell shortof the market’s expectation for the first vote for a raterise. In testimony to the Treasury, MPC membersstruggled to explain the inconsistency between stronggrowth and employment gains, and weak wage growthand inflation. Carney sided with the latter of the twocategories, believing that benign wage growth wassymptomatic of substantial spare capacity concentratedin the labour market, presenting a dovish stance.

The mixed messages from Governor Carney arebecause he must convey his personal view as well asrepresent the MPC consensus. The inconsistency in hiscommentary reflects the divergence of opinion amongthe Committee as a whole as they try to interpretconflicting data. Consensus will ultimately decidemonetary policy, not individual members. Officialcommunications suggest an increasing majority of theMPC believe strong nominal growth rates andinvestment support the case for higher interest rates.Carney’s Mansion House speech and the June minutesboth point to an interest rate rise this year. We believethe first rate rise will come before year end, possiblyNovember, with an average 25 basis points of hikesevery quarter, data dependent. The terminal rate islikely to be 2.5%, significantly below the 5.0% historicalaverage as a failure to address structural deficienciesresult in a sluggish and more fragile UK economy.

STERLING OutlookSterling-dollar trade is a slow race of which centralbank hikes rates first. Although monetary policytightening is undoubtedly the next step for both, strongnominal growth rates and hawkish central bank rhetoricmeans the UK 2 year yield consistently outpaces its USequivalent. Since mid-2013, sterling-dollar has been anupward sloping line supported by a widening interestrate differential. The sterling-dollar exchange ratecurrently trades broadly in line with measures of its realeffective exchange rate, suggesting that while themarket is long sterling, positions are not yet stretched.Looking at the front end of the short sterling curve,there is a risk that the market has priced in large ratehikes in the near term, meaning the rate may struggleto build traction once the first hike is introduced.However, at the long-end, market pricing is consistentwith central bank guidance of a 2.5% terminal rate.

House Prices Continue to Rise Even As MortgageApprovals Fall


Sterling-dollar is likely to trade towards $1.74 and $1.76by the end of Q3 and Q4 on the central bankannouncing the first rate hike. However, sterling-dollarwill struggle from here as markets digest slow andgradual UK rate rises and the Fed moves to hike in mid-2015. Sterling-dollar is likely to moderate to $1.73 and$1.71 by end Q1 and Q2 respectively.

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EURO MacroeconomyEurozone first quarter GDP growth was, in a word,disappointing. In a quarter where the economy benefittedfrom warm weather and a restocking of inventories, theeconomic block scraped a meagre 0.2% growth. TheEurozone road on the coat tails of German output, whichcontributed the majority of gains. Economic indicatorsnow suggest the German export giant slowed in thesecond quarter, with obvious negative implications for theentire Eurozone.

Domestic Demand Will Underpin Future EurozoneGrowth


Despite the disappointing headline figure, positivetrends are forming beneath the surface. Householdconsumption edged up 0.1% in the first quarter,following three quarters of modest growth. Thisheadline number underestimates true householddemand, as weaker oil consumption due to the warmerwinter and tax changes in different countriestemporarily depressed spending. Underlying privateconsumption has strengthened in tandem with risingconsumer confidence. Surveys indicate this trend willcontinue into the second quarter, as macroeconomicuncertainty recedes and the labour market stabilises.The resurgence in private domestic demand even ledimports to outpace export growth in the third quarter.Despite market concerns of deflation, low inflation ishaving a remedying effect on real disposable income,boosting household consumption. Initial estimates ofrobust retail sales growth in Q2 suggest consumptionwill be a strong driver of future growth.

Business investment is also benefitting from the sameshoring up of confidence. Capital formation has risenfor three consecutive quarters, reflecting improvementsin demand, profit and financing. The recovery ininvestment levels is surprising considering bank lendingto non-financial corporates remains in negativeterritory. Companies have drawn down on cashbalances or taken to capital markets to raise funds, anoption limited to large companies. A stabilisation andsubsequent pick up in annual loan growth tocorporates, however, suggests a turning point inlending is approaching. Increased credit supply should

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accelerate the investment recovery.

Another optimistic evolution in the Eurozone is in termsof balance. The Eurozone’s June PMI Compositeunderlined the continued resurgence of the peripheryeurozone economies. Outside of Germany and France,output in the rest of the Eurozone grew at the fastestrate since August 2007. This underlines that theperiphery is catching up with the core and thedangerous precedent of a two tier Eurozone, a sluggishperiphery heavily indebted to the robust core, ischanging. Just as the Eurozone system of Target 2balances shows the periphery is paying down itsliabilities to the core, the rest of Eurozone is now lessdependent on the core economies for growth. TheEurozone is moving toward a more complete economicblock, with a level playing field between all memberstates.

Low levels of Eurozone inflation have drawn unfaircomparisons with Japan. There were several structuraleconomic barriers that led to Japan’s lost decade.Japan’s struggle with inflation was characterised by lowwage growth, a lack of capex and firms hoarding cashon their balance sheets. The Eurozone, in contrast, hasexperienced resilient wage growth, with compensationper employee up 1.3% on the year in the first quarter, inline with productivity gains. Investment is recoveringand although companies held higher liquidity levelsthrough the crisis, corporate deposit growth has slowedas business start to invest.

Deflationary pressures in the eurozone are very muchconcentrated in food and energy prices. Unprocessedfood inflation registered -2.1% in May while energyprices improved modestly to 0.2% annual growth.Services price inflation at 1.3% provides further evidencethat Eurozone disinflation is the result of weaker globalcommodity prices, exaggerated by a stronger euro, andnot structural disinflation. The re-emergence in privatedomestic demand will support price growth goingforward. In June, German CPI rebounded due to higherrecreation and facilities prices. June’s Composite PMIreport also showed the first whiff of inflation withoverall prices charged showing the smallest reductionin 27 months. Manufacturers even felt confident enoughto raise prices for the second consecutive month. Lowinflation was the normal response to a weaker economyexaggerated by external factors. Price growth willrebound in line with private domestic demand and GDP.



EURO Monetary PolicyThe June ECB meeting saw the central bank unleashingalmost every monetary policy tool at its disposal in abid to counter the two chief culprits behind disinflation– tighter money market conditions and the exchangerate. A month after the measures and with QE the onlything left in the toolbox, the new measures are yet tohave a noticeable effect.

Eurozone Disinflation Is Limited to Commodity Prices


Euro-dollar is sticking below the $1.38 level of concern.However, at this level, the exchange rate will ultimatelycontinue to deflate imported food and commodityprices and drag down overall inflation prints. The levelof funds banks are stashing at the ECB’s deposit facilityis also unchanged, along with the level of Eurozoneexcess liquidity. Banks have also accelerated theirrepayment of LTRO funding. This failure to force banksout of the deposit facility and into lending in theinterbank market shows the level of fear andretrenchment that is still ongoing in the Eurozonebanking system.

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The ECB’s ambush of policy measures was really just anefficient solution for the wrong problem. Banks don’tneed lower financing costs, they need lower capitalcosts. Right now the Eurozone’s banking system is non-operational and this means that the ECB effectivelycan’t do anything until the recapitalisation is completedthrough the ECB’s Asset Quality Review. It hasunleashed a flood of liquidity into the system, but untilthe transmission valve is fixed they won’t know itsimpact either way.

The ECB has stacked up the fire logs and is waiting forthat first spark for their policy to take effect. The Bank’sGoverning Council now needs to proceed with caution.It was only 5 quarters into the UK’s recovery before therisks of low interest rates and abundant liquidity led to aproperty market boom. If, in the long-term, the ECB’smeasures fail to stimulate lending to the real economy,Draghi will go over the banking system’s head,announcing a concrete plan to lend to the Eurozone’sbusinesses themselves, through the Asset BackedSecurities markets. As well as the logistical and politicalproblems with QE, there is evidence that the policywouldn’t work in the Eurozone’s banking based systemto force capital out of the economy and weaken theeuro. QE speculation itself has led to substantial capitalinflow, through the net portfolio and direct investmentsection of the financial account. For now the ECBneeds to bide its time-and the central bank remains along way away from turning on the printing presses.

EURO OutlookThe traditional correlation of EURUSD to the yielddifferential between 2 year US Treasuries and GermanGovernment Bonds has collapsed. In 2012, thecorrelation broke and euro-dollar realigned itself to anegative correlation with peripheral yields. Draghi’sthree little words “whatever it takes” changedeverything in the euro crisis, even how the currencytrades. The euro no longer trades on fundamentals oreven diverging monetary policy but on capital flows.Draghi’s August 2012 speech first raised the prospect ofoutright sovereign bond purchases. Falling Eurozoneinflation further fed speculation of central bankpurchases, leading to capital inflows into peripheralbond markets with the euro trading increasingly higher.

EURUSD Trades On Capital Flows Not Monetary Policyor Fundamentals


The reasons behind the euro’s persistent appreciationcan be found in the monetary dynamics in the euroarea. Net portfolio investment shows sizeable capitalinflows into Eurozone equity and debt securities, as theexpectation of QE encouraged capital to flow into theeconomic area instead of forcing it out. In April, netportfolio investment inflows stood at €142 billion, albeitdeclining slightly from the previous 12 months. Thesurge in MFI’s net external asset positions provides atimeline for the influx of foreign capital into the euroarea. The substantial acceleration in external positionssince mid-2013 corresponds with lower Eurozoneinflation and increased speculation of QE. However, thedemand for Eurozone sovereign debt is not just limitedto foreign investors. Domestic investors are desertingdeposit instruments in favour of higher return in thebond market. Short term deposits fell 6.8% in April fromthe previous year, and were consistent with a decline inM3 growth. In their monthly reports, the ECBconsistently blames the fall-off in M3 on “funds beingshifted towards better remunerated assets outsidebroad money”. This underlines the internal carry tradethat is ongoing with the Eurozone area and destroysthe argument that negative deposit rates will turn theeuro into a funding currency.

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Peripheral bond market contagion still exists but now itspositive contagion. Increased QE speculation leadsbond markets to rally together when previously theysold off together. This suggests peripheral bond marketstrade as a single asset class and the euro exchange rateis determined by the substantial capital inflows floodinginto this market.

We argue that the ECB’s aggressive June measurescould in fact strengthen the euro further. Stopping theSMP sterilisation broke the first barrier to ECB QE andthus raised markets expectations for the policy. Thebrunt of downward pressure on euro money marketrates has now passed and instead of boosting excessliquidity, the ECB’s measures may end up reducing it.This risk is that banks will continue to acceleraterepayment of LTRO funds, especially ahead of the finalredemption dates in January and March 2015. Althoughthe ECB’s TLTRO will help to mitigate some of thisliquidity drain, it won’t be enough to offset it. The 7%balance sheet cap on access to TLTRO funding will alsolimit the take up of the measure. Eurozone MFI’scontinue to deleverage ahead of the Asset QualityReview, meaning they have limited appetite to raisefunding for lending purposes. The ECB reported€66billion in private sector deleveraging in the first fourmonths of the year. There is a tail risk that excessliquidity could collapse in the Eurozone ahead of theLTRO redemption dates, forcing money market rates toreverse their losses and trade higher. Higher moneymarket rates are ultimately euro supportive.

Euro-dollar is likely to trade towards $1.39, $1.42 and$1.41 by the end of Q3, Q4 2014 and Q1 2015respectively. Increased speculation of US rate hikes islikely to add downward pressure to the exchange ratein Q2 2015 with the rate approaching $1.40.


JAPANESE YEN MacroeconomyJapan appears to have weathered a retail sales hike.Although retails growth declined 13.7% on the month inApril, the nominal level of sales remains moderatelyabove February’s level. Corporate expenditure was evenmore resilient to the higher tax rate. Although down onthe month, both machine tool orders and machineorders remain substantially above 2013 levels. A surgein construction orders should also help to offset anydecline in domestic consumption, as the tsunamirebuilding effort is stepped-up and construction for theOlympics begins.

Japan Weathers the April Sales Tax Hike


The BoJ’s aggressive monetary stimulus may have beensuccessful in stirring inflation. Even if its sustainabilityremains to be decided, the resultant increase inconsumption and investment survived its first test of ahigher sales tax. However if Abenomics is to work in thelong-term, the government needs to shoot the thirdand final arrow of structural reform. Japan faces anaging labour force thus the only way it can increasegrowth is to raise productivity. Japan also remains atthe mercy of capital markets with the single biggestdebt burden of the developed world. It needs to addressthis problem before the debt levels per capita cripplesthe economy.

Abe announced a broad array of reform objectives inmid-June to a subdued market reaction. Abe effectivelydrowned the report with details but what was missingwas direct policy action. Abe third arrow of reformswere certainly ambitious and targeted. The question is,however, does Abe have the political bottle to take onJapan’s protected industries and major lobby groups?

Japan’s third arrow reforms can be categorised underfour headlines – Promotion of Investment, StrengthenUtilisation of Human Resources, Creation of NewMarkets and Global Economic Investment. The mostpromising reform is alterations made to theGovernment Pension Investment Fund which will nowbe benchmarked to equities indices and co-invest ininfrastructure projects. At Y1.26trillion, the GPIF is thebiggest of its kind globally and a drive for it to invest inequities could establish a market precedent and lead toless saving and more equity investment in Japan as awhole. A Stewardship Code to establish a more investorfriendly business environment is also likely to behelpful. The Code, now signed by 127 institutions, aims

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to take on Japan’s corporate governance issues bytackling protected industries and corruption whileencouraging greater fiduciary responsibility. This shouldhelp to rehabilitate Japan’s reputation when it comes toinvestment and encourage firms to pay higherdividends instead of retaining cash on their balancesheets. It is a first step but certainly not a panacea.

Other measures lacked real bite. Abe set explicit targetsfor increasing female participation rates in the labourforce, with more child care facilities. He also alluded toremoving a spousal tax deduction system that manybelieve disincentives women to work, but failed to putforward the legislation needed. Plans to accept foreignconstruction workers to accelerate the tsunamireconstruction effort, and ahead of the Olympics, arehampered by heavy regulation and a maximum visalimit of 5 years. Allowing in foreign healthcare workersdesperately needed to care for Japan’s elderly is so farlimited to special strategic zones. Admittedly this is animportant cultural step but Japan’s economy simplycan’t wait for society to come around.

A 2.4% reduction in the corporate tax rate wasimplemented since April 2014. Japan’s corporate taxrate is one of the highest in the world at 35% andbringing it below 30% should make the economy’sindustries more competitive to global businesses, andsupport foreign direct investment. However the tax cutthreatens to undermine Abenomics’ second arrow offiscal sustainability, and Abe has yet to announce wherethe extra tax revenue will come from. The most likelyoutcome is an increasing tax burden on consumers, adangerous policy as Japanese consumers have alreadystomached a sales tax increase and higher import costsdue to a weaker yen. According to recent data, theirspending behaviour is also far less resilient to highertaxes than corporate investment. Japanese companieshistorically hoard cash on their balance sheet asopposed to investing. The average Japanese liquidityratio is 12.5 in Q1 2014, against a recommended level ofbetween 1 and 2. Lower corporate taxes could actuallyhave an adverse impact, as corporates could respond byincreasing their retained earnings and thus taking morecash out of circulation in the economy. This is withoutmentioning the fact it will undermine fiscalconsolidation efforts in an economy that has Y1quadrillion in debt and a dwindling labour force torepay it with.

Abe’s government has identified the reforms need toturn temporary economic growth from monetarystimulus into real sustainable growth. The PrimeMinister now needs the guts to implement them andresist the pressure from protected industries that havebeen pandered to for far too long. Japan’s powerfulagricultural co-operative remains a large obstacle inagreeing to the US and Japan’s proposed trade deal.The third arrow will have some effect in lifting growth,especially through the GPIF reforms but follow uparrows will be needed to put Japan on a sustainablegrowth path.



JAPANESE YEN Monetary PolicyA flaw in Abenomics’ first arrow has recently emerged.From January, import price growth began to steadilydecline, as the impact of a weaker yen began to fall outof the annual calculation. In response, nationwide CPIbegan to wobble. National CPI, excluding fresh food,flatlined at 1.3% for four consecutive months fromDecember. The sideways movement in price growthoccurred in line with a stabilisation and then fall off inmoney supply growth. Abenomics overlooked anessential mathematical truth – in order to achieve aconstant rate of growth you have to add an increasingamount in nominal terms. Effectively maintaining thecurrent rate of QQE is not enough. In order to achieveits target of 2% the BoJ has to increase QQE toperpetuate a further depreciation of the exchange rate.

The Sales Tax Impact Hides Weakening InflationaryPressures


Admittedly, broad inflation managed not to collapse inline with falling import prices, suggesting that at leastsome of the turnaround in price growth is the result ofdomestic demand. The improved economic optimismand higher inflation expectations had a tangible impacton the ground, increasing expenditure and corporate

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Japan CPI (% Change YoY)

investment. We still maintain that structural reforms areessential to securing the positive development the BoJhas put in place.

The economy’s resilience to the April sales tax hike leftbond and forex markets to price out expectations of anincrease in QQE that once looked like a sure bet.Comments from the BoJ itself have backed up themarket re-pricing. In fact the BoJ have taken a hard lineon further easing. Not only do they seem less willing inaccelerate the increase in their balance sheet but theBoJ governor has publicly put pressure on Abe to act.Effectively the Bank is unwilling to allow itself to betrapped into a continuous cycle of increasing assetpurchases to maintain inflation rates. The governmentneeds to implement structural reforms otherwise theBank’s balance sheet is in jeopardy. In a recent speechto Japan Association of Corporate Executives, BoJGovernor Hiroki Kuroda called structural reform“critical”. Highlighting the BOJ’s growing predicament,Kuroda forecast that underlying inflation would slow to1%, “as upward pressure from import prices – inparticular energy prices- will likely wane”. HoweverKuroda brought his speech to a conclusion with apoignant comment. Even if Japan’s potential growthrate does not rise due to structural reforms, “the Bank’smission to ensure price stability remains unchanged”.Effectively, structural reform or no structural reform, theBank will achieve its 2% price target. Entering anunprecedented policy of unlimited asset purchases thatcause the bank’s balance sheet to balloon is effectivelyan all or nothing policy. The BoJ is in this until the end.They are likely to use the threat of inaction to force thegovernment to implement reforms – a policy which hasso far worked. However, falling inflation rates in linewith softer money supply growth will test the BoJ’sresolve and we foresee them caving towards year endand increasing their target for QQE. In the interim, theBoJ may also extend the timeframe for how long thecurrent QQE programme will continue.

JAPANESE YEN OutlookUSDJPY has decoupled from its traditional drivers inrecent months and instead appears to be correlatedwith a straight line. The exchange rate’s historicallystrong correlation to interest rate differentials hasweakened considerably through the last year. In the sixmonths to July, USDJPY’s correlation to the yielddifferential was calculated at 0.473. In the six months toend June, it stood at just 0.256. The yen’s negativecorrelation to the Nikkei equity index, whichstrengthened since the introduced of Abenomics, hasalso broken down. The Nikkei’s recent 3.4% rally sincethe May 19th low corresponded to a mere 0.60% movein USDJPY. In some respects, it is a positive signal thatJapanese growth is no longer dependent on a weakeryen. However it doesn’t answer the question: what isdriving the yen?

USDJPY Has Broken Away From Its Traditional Drivers


USDJPY seems to be taking its direction from EURJPY,ever since the ECB’s June 6th policy decision andsubsequent speculation that the euro could be a rivalfunding currency. An interesting dynamic also appearedin EM – yen crosses with the yen appreciating against anumber of the former “fragile five” currencies. Thisshatters previous speculation of a carry tradingenvironment and suggests sideline geopoliticalconcerns have sparked a risk reversal in EM carry and issupporting USDJPY on the downside. This is backed upby CFTC positioning data which suggesting yen shortpositions have been squeezed since March. The yenlosing ground as a funding currency and geopoliticalconcerns have caused USDJPY to diverge from itsfundamental drivers.

The USD-JPY 2 year yield differential continues towiden as the US economy recovers from the winterfreeze and inflation concerns raise the prospect ofpremature tightening in the US economy. Thedivergence in monetary policy suggests the yielddifferential will continue to be dollar supportive. Japan’strade balance continues to deteriorate as domesticfirms relocate their manufacturing operations abroad.This has led to a persistent decline in Japan’s currentaccount balance. Capital outflows in the financial

Jul 2013 Oct 2013 Feb 2014 Jun 2014

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

88

90

92

94

96

98

100

102

104

106

108

Nikkei 225 Index USD/JPY

account will be perpetuated by the recent GPIF reformsand also argue for a structurally weaker yen. The riskthe BoJ will be forced to increase its QQE target isgreat, and the BoJ will be quick to act if their progresson inflation looks to be in jeopardy. The corporate taxrate reduction suggests a future increased tax burdenon consumers and the BoJ having to ease policy futureto offset the negative demand effect. We forecastUSDJPY to trade towards Y103, Y105, Y107 and Y104 inQ3, Q4 2014, Q1 and Q2 2015 respectively.


REALISED VOLATILITY


EUR/USD

Jul 2012 Jan 2013 Jul 2013 Jan 2014 Jul 2014

1.20

1.22

1.24

1.26

1.28

1.30

1.32

1.34

1.36

1.38

1.40

4.00

5.00

6.00

7.00

8.00

9.00

10.00

CAD/USD


0.96

0.98

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

GBP/USD


1.45

1.50

1.55

1.60

1.65

1.70

1.75

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

CHF/USD


0.86

0.88

0.90

0.92

0.94

0.96

0.98

1.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

NZD/USD


0.76

0.78

0.80

0.82

0.84

0.86

0.88

0.90

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

16.00

GBP/EUR


0.76

0.78

0.80

0.82

0.84

0.86

0.88

4.00

5.00

6.00

7.00

8.00

9.00

10.00

AUD/USD


0.86

0.88

0.90

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

6.00

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

JYP/USD


75.00

80.00

85.00

90.00

95.00

100.00

105.00

110.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

Realised volatility reflects the actual volatility derived from a time series of currency spot prices. The measure iscalculated using the annualised standard deviation of daily returns over a three month period.

– Currency (LHS) – Realised Volatility - 3 months (RHS)

Source: Bloomberg data as at 08.07.2014

MARKET POSITIONING


EUR/USD


1.20

1.22

1.24

1.26

1.28

1.30

1.32

-200,000.00

-150,000.00

-100,000.00

-50,000.00

0.00

50,000.00

100,000.00

CAD/USD


78.00

79.00

80.00

81.00

82.00

83.00

84.00

85.00

-20,000.00

-10,000.00

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

GBP/USD


1.54

1.55

1.56

1.57

1.58

1.59

1.60

1.61

1.62

1.63

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

CHF/USD


1.00

1.01

1.02

1.03

1.04

1.05

1.06

1.07

1.08

1.09

-40,000.00

-30,000.00

-20,000.00

-10,000.00

0.00

10,000.00

20,000.00

NZD/USD


0.98

0.99

1.00

1.01

1.02

1.03

1.04

1.05

1.06

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

GBP/EUR


0.02

0.02

0.02

0.02

0.02

0.02

0.02

0.02

-160,000.00

-140,000.00

-120,000.00

-100,000.00

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

AUD/USD


0.96

0.97

0.98

0.99

1.00

1.01

1.02

1.03

1.04

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

JYP/USD


0.76

0.77

0.78

0.79

0.80

0.81

0.82

0.83

0.84

-5,000.00

0.00

5,000.00

10,000.00

15,000.00

20,000.00

25,000.00

30,000.00

35,000.00

The US Commodity Futures Trading Commission releases a snapshot of traders positioning on a weekly basis. Thenet non-commercial positioning provides a proxy for broader speculative activity in the FX market and as suchreflects market sentiment regarding individual currencies and can signal overstretched market positions.

– Currency (LHS) – Realised Volatility - 3 months (RHS)

Source: Bloomberg data as at 08.07.2014

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