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Flows: The Currency Cartel Carry Cycle

Released 12/09/13

Since 2008 the single-minded focus of central banks has been the repair of the balance sheets of the major international banks and sustaining the debt addicted funding for sovereigns consuming more than they produce, reeling from slow growth and chronic unemployment and incapable of fashioning Fiscal, Public & Economic Policy solutions. In the world of the blind, one eyed Monetary Policy has become King!

The urgently growing problem now is a crisis in the global pension industry. The Macro Prudential strategy of Financial Repression (negative real rates, penalized savings, regulatory arbitrage and currency debasement) has worked effectively for the banks and sovereign governments but has left those industries requiring 'yield' in dire straits. It cannot be stressed enough how important pension and insurance investments are to the life blood of the global economy. Banks may get the press but those less understood, toiling in the shadows, keep massive economic segments such as commercial real estate (temporarily) afloat.

The solution has been for these financial intermediaries to change regulatory and fiduciary risk restrictions and increase riskier equity asset allocations. The magnitude of underfunded pensions, the growing disconnect of the "8%" rule and the tsunami of retirees now beginning to make claims, is forcing the liquidity pumps to be sped up - not "tapered'. A 'Madoff Moment' is near without continuing and uninterrupted flows (see: "FLOWS: Liquidity, Credit & Debt" for detail).

Euro Pressure Needs Relief

The equity markets in Europe and the US have been on a tear as the new world of ABE-nomics reignited the dormant Japanese Carry trade and helped the pension industry in a stealth fashion.

The correlations are indisputable. Even Goldman Sachs recently outlined it couldn't explain a 22% differential between what its combined Macro, Valuation and Risk models suggested the S&P 500 should be trading at.

The new problem is the strength of the Euro.

The Euro is seen to now be stalling the EU recovery and potentially triggering another EU banking crisis as CEE (Central and Eastern European) loans (denominated in Euros), are rapidly becoming non-performing. (See: "Euro Pressure Going Critical")

Nowhere To Hide - Nowhere To Run

The "Carry" trade has been in full force since the 2000 technology bubble burst. For 80 months a 41.6% devaluation in the US dollar powered a US$ Carry Trade with low interest rates. With the financial crisis the Carry Trade shifted and the Euro Carry emerged with 24.0% currency devaluation over a 51 month period. Since October 2011 the Yen has resurfaced as the excepted Carry Trade. It needs to be appreciated that this is a planned rotation by the currency cartel, which controls 90% of the globe's currency trade.

As long as the Cartel all debase together, in a coordinated 'rotating' fashion, there is seen to be nowhere to hide!

Everyone is presently focused on the central bank balance sheet growth. We did earlier as we identified very coordinated patterns during 2010 and 2011.

Race To Debase

We additionally saw the Cartel's debasement strategy unfold and tracked its coordinated responses.

The 'Original Sin'

What we are now watching however, as part of our FLOWS work, is the shifting mechanics of the Carry Trade. The "Original Sin" of International finance is to always borrow in a currency that is devaluing and trending lower. Additionally, and less appreciated is to flow investments through the currency cross that gives the best differential change against the carry currency.

First, let's talk about the sustainability of the current "Carry" in the Yen and then recent developments in what may be emerging as the new currency cross of choice. The current equity market melt-up is dependent on this for its sustainability in the near to intermediate term.


The "Three Arrows" of ABE-nomics are not working and we can expect sustained and likely increased levels of BOJ Balance Sheet expansion.

ABEnomics 3-Arrow Policy

Hugh Hendry made headlines when he recently became a 'tactical' market bull. An excerpt from his report is quite telling:

Japan 5-Year Breakeven Inflation

Consider the US Treasury Inflation Protected Securities (TIPS) market. As you know, we allocate a lot of time and risk capital to equities. Their malleability allied with low transaction costs and liquidity makes them an excellent way for us to invest in our macro narratives. But we find it hard to buy and sell equities based on valuations. Doing it like this is just too imprecise. So we prefer the certainty of inflation expectations: you should be long equities if inflation expectations are trending higher -- or more specifically for us when the 10-year inflation expectation, derived from the TIPS market, is greater than its 200 day moving average.

Over the last decade you could have done this and nothing else and escaped most criticism. A simple trading rule where one is long S&P futures when the condition is met, and flat otherwise, has produced a return of 75% since the 1st of January 2003 (around the bottom of the TMT crash). A long-only strategy has produced better gains - almost 95% - but using the rule would have lowered your maximum drawdown from 56% to just 20%. So once you adjust for volatility you can say that you would have done better investing guided by trend inflation expectations than not. The 10-year expectation moved below its 200 day moving average in April this year. And yet we have taken a resolutely contrarian message from this signal. Don't sell equities. China's pledge to maintain high GDP growth rates by ploughing on with capacity enhancing supply additions to its fixed capital formation, even at a time when the still risk averse banking system in Europe and America is failing to produce a consumer boom in the West, is fast building global deflationary pressure. That's the resounding message from the TIPS market. And in a world of two way causality, that could continue to prove immensely bullish. Why? Because the Fed uses this criteria as its principal benchmark for determining whether to taper or not.


The most senior policy makers at the Bank of Japan were unceremoniously removed from office and monetary policy was set, instead, very loosely, propelling yen asset prices higher. The stock market leapt by 60% on the news and the currency weakened by 20%. And, as the chart above of the Japanese five-year break-even inflation expectation reveals, one should be long their stock market. We still value the one-touch at our purchase price today, and with the market approaching 16k and trending higher, who is to say where it will trade in April 2018?

Central banks balance Sheets, Percent of GDP

Currency Cross - Short Term Shift

We showed above the tight correlation between the EURJPY and the S&P 500. What is now becoming more correlated is the GBPJPY!

Japanese Carry Trade Powering Credit

Markets react to data. The U.K. is a small open economy. It has thrown the kitchen sink at growth and it may finally be beginning to be show some results. Remember when Carney took the helm of the BOE people were quite pessimistic, worried and then from there on things started to turn. So there was already a backlog obviously. Then the confidence boost given the forward guidance and the change of strategy helped.

What were the drivers behind that growth? The main ingredients for the growth that we're seeing are the funding for lending that has really spurred the credit creation more than it has on the continent. The stabilization of the euro area as a whole has helped confidence. People don't ask a lot about what's happening there, which is a change. They ask more about Scotland than about the euro zone. It's telling. Then the third thing, which is more structural, the U.K. labor market has operated in a strange way relative to previous cycles, a more continental way. So there's been less firing given economic circumstances, which has meant that more people kept a job. Rates went down and that helped their disposable income stay stable or actually grow. That has helped consumption and get the economy going again. So there's a combination of forces and the market has reacted to that. The market is likely not excessive. It's taking the view that the BOE may be the first to hike in the cycle in late 2015 ahead of the Fed.

S&P500 Correlation

Bloomberg recently laid out the case that the British Pound may be set for gains versus Japanese Yen:

The pound may continue to climb versus the yen as risk appetite remains buoyant and the currency cross breaks above key resistance.

The technical outlook may attract investors to the options market. GBP/JPY has been most highly correlated with the S&P 500, a proxy of global risk appetite, among the variables of the cross-asset correlation matrices of the Bloomberg Currency Chart book.

The daily correlation in the last month between the percentage change of the exchange rate and that of the S&P 500 stands at 0.61.

The figure for the last three months is 0.44. The equity index hit a new record high last week. Loose monetary policy around the world may continue to boost stocks.

In addition, the moving-average cross-over technical overlay rule of the carry-trade tracker signals JPY funded carry trades versus a basket of the currencies of commodity-producing and emerging- market countries (AUD, BRL , MXN, NZD, TRY and ZAR) should be opened.

It also indicates CHF and USD funded carry trades should be closed.

The long/flat signal is provided by a moving-average crossover technical overlay rule. The investor goes long the carry-trade basket when the five-day moving average of the cumulative returns is above the 30-day moving average and then closes that position and goes flat when the five-day moving average falls below the 30-day moving average. (See: Rosenberg, Michael R., Bloomberg FX Market Insights, July 8, 2009.)

JPY Funded Trades

GBP/JPY appears only somewhat overvalued. It is about 19.3 percent above a Bloomberg Brief calculation of its purchasing-power-parity equilibrium level and 2.7 percent below its 10-year moving average. The average of those two numbers is 8.3 percent.

The technical outlook for GBP/JPY also appears positive. The currency cross is pushing through resistance created by the 38.2 percent retracement line of the decline from the 2007 high to the 2011 low at 168.13. The next major resistance level is created by the 50 percent retracement level of the same sell-off at 183.97.


The recent rally has left the pair well above support created by the 55-day moving average, currently at 159.31. That may attract investors to the options market. For example, additional gains could be captured with an at- the-money three-month GBP call/JPY put. It would cost 1.97 percent of the notional value of the trade, according to the Bloomberg Professional Service.

The rally of the pound versus the yen may be greater than that of the U.S. dollar versus the Japanese currency as a result of seasonal patterns. The U.S. dollar has weakened over the last 13 years during the month of December, especially versus the euro, the Hungarian forint, the New Zealand dollar, the Polish zloty, the Swedish Krona and the Swiss franc.

Fiat Currency Cartel Control

The depreciation has averaged 2 percent versus the euro, 1.7 percent versus the Hungarian forint, 2.2 percent versus the New Zealand dollar, 2 percent versus the Polish zloty, 1.8 percent versus the Swedish Krona and 2.2 percent versus the Swiss franc.


We expect increasing levels of BOJ Balance Sheet Expansion, a strengthening UK Sterling and a shift in the Carry Trade dynamics. This may be unsettling to the equity markets in the short term as the shift takes place but is likely to result in a continued melt-up of the markets in the Intermediate term.

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