Last month I penned an article titled, “Implications for the Stock Market and Gold with a Yen Rally” in which I laid out the case for the US dollar (USD) to weaken relative to the Yen in the coming month and what the implications would be for the stock market, volatility, and gold. A key excerpt from the article is provided below (emphasis added):
Implications for the Stock Market and Gold with a Yen Rally
There is a large divergence between the USD/Yen exchange rate and their associated interest rate differentials and my belief is this divergence will be resolved by the dollar weakening relative to the Yen in the weeks and months ahead. Should this occur we could see a rough start to 2015 with stocks weakening while gold rallies. The biggest theme I see for 2015 is a pickup in volatility and the best advice for that kind of climate is to stay humble as the market whips around here and there and confuses bulls and bears alike, and to stay nimble as market volatility always creates opportunities.
My call for a Yen rally was based on two main factors: one, the interest rate spread between the U.S. and Japan and, two, valuations. Since that time the spread between interest rates has declined even further which suggests the Yen rally should continue. So far, it has moved from a low of 121.85 to the USD on 12/08/14 to its current (as of yesterday) 116.38. The gap between the interest rate spread and the JPY/USD exchange rate remains large and suggests the readjustment should continue in the near future as the fourth major gap between the two series over the last decade is closed.
Source: Bloomberg
As mentioned in the December article, there can be two ways the series readjusts, which is the dollar falls relative to the Yen or U.S. interest rates rise faster than Japanese rates. A Yen rally is typically associated with weak stock market returns ("risk off) while a Yen decline fuels the Yen carry trade and risk assets rally ("risk on"). The weak Yen has been a significant source of liquidity to the markets since late 2012 as has Fed quantitative easing (QE), which we know is now over. Should the Yen strengthen in the current climate we would have an investment backdrop not seen since 2012 when the Yen rallied and there was no Fed QE market support.
Shown below is the S&P 500 in the top panel, the USD/Yen exchange rate in the middle panel, and the Fed’s balance sheet in the bottom panel. Periods of when we had either a falling Yen or rising Fed balance sheet are highlighted in yellow where areas in green are when we had both a falling Yen and rising Fed balance sheet. In red I show periods when the Yen was falling and the Fed’s balance sheet was either stable or declining. As you can see, the strongest returns occur when the USD is rallying against the Yen and the Fed’s balance sheet is expanding, while the red periods show weak returns when we have just the opposite. As mentioned above, this is the first time since 2012 that we had a strong Yen and no expansion in the Fed’s balance sheet and, as seen by the red shaded boxes, typically the market has a tough time advancing against this backdrop.
Source: Bloomberg
In my December piece I also highlighted how the Yen was significantly undervalued relative to the dollar on a purchasing power parity (PPP) basis (click for definition), which I won’t go into here but mention it as another support for why the Yen should strengthen ahead. In addition to a weak stock market as one implication of a strong Yen the December piece also highlighted two other beneficiaries: gold and volatility.
Gold and the Yen appear to be strengthening together and given how oversold both are this countertrend move could have some near-term legs to it. With the recent Swiss National Bank announcement to remove the cap to the Euro, this is also adding fuel to gold’s rally.
Source: Bloomberg
Here's What the Swiss Central Bank Just Did and Why It's Such a Shocker
[Yesterday] the Swiss National Bank shocked the world when it announced it would remove the cap it had in place to prevent the Swiss franc from rising too high against the euro…
In a note to clients, Société Générale currency strategist Kit Juckes explains that the SNB came to the conclusion that it didn't make sense for it to keep on an endless path of buying more and more euros just to keep the currency down. And that perhaps the bank felt that all the euros it was accumulating on its ballooning balance sheet were becoming a liability.
Furthermore, the European Central Bank is seemingly on the verge of launching its own quantitative easing program, which should put more downward pressure on the euro and further increase the cost of holding the peg.
The Swiss Franc saw a massive jump relative to the Euro and the dollar yesterday and given the speculative short position in the Swiss Franc relative to the dollar (shown in red below is net short position in the Franc by speculators) we could see the Franc appreciate further.
Source: Bloomberg
Because the Swiss Franc and gold have tended to move in the same direction, the recent rally in gold caused by Swiss Franc short covering may continue further. What is interesting is that both gold and the Swiss Franc had parabolic moves in 2011 and just before the peak in gold is when the Swiss pegged their currency to the Euro and both went into a bear market. Perhaps the recent removal of the cap to the Euro may signal the bottom in gold? Time will tell.
Source: Bloomberg
As highlighted in the December piece, in addition to a weak stock market and stronger gold price we should also expect greater volatility with a strengthening Yen.
Source: Bloomberg
Summary
My last several articles have highlighted the likely pickup in volatility and potential weakness in the stock market. We still have to contend with the ECB meeting on the 22nd and Greek elections on the 25th, but once these events are behind us the market will likely breakout of its trendless pattern and the concern is that fading liquidity and a potential growth scare could lead that breakout to the downside. In the words of David Tepper, “Don’t be so freakin’ long.”
