Regular readers know that I am a big proponent of observing the market's embedded inflation premium, which is the extra compensation investors command for inflation risk. All else equal, inflation premiums govern real interest rates, the slope of the yield curve, the value of the dollar, commodity prices, and risk multiples. In 2013, despite continued QE, falling inflation premiums were the principle driver of assets prices, and as the Fed removes stimulus they will no doubt continue to govern markets in 2014.
In 2013, the S&P 500
(INDEXSP:.INX) returned 31.5%, but the multiple expanded 26.0%. Looking at that statistic, one would assume that QE was responsible for this multiple expansion via a weak dollar -- yet, for virtually all of this multiple expansion, the dollar has strengthened. If QE is dollar bearish, how can it be pushing stocks higher when the dollar is also rallying? Contrary to the consensus view that QE is responsible for the rally in risk, it is actually a stronger dollar that is responsible for returns driven by multiple expansion. This is rational because a falling inflation premium allows investors to pay more today for cash flows tomorrow, because more of these cash flows are expected to be real.
To understand how the dollar has impacted risk multiples, you need to go back to 1995 when Fed tightening sent the dollar soaring against the yen. The USDJPY went on to strengthen by 85% from 1994-1998 and, over the same period, the S&P rallied by 160%, of which 83% was multiple expansion. Since the 1998 top in USDJPY, the Fed unleashed the era of easy money and long periods of negative interest rates. The USDJPY fell by 50% over the following decade, and you know what happened to stocks.
Because inflation erodes the future purchasing power of coupons, it is enemy number one for the fixed-income investor. Thus bond yields are highly sensitive to inflation risk. When inflation risk is high, the yield curve and the risk curve both steepen to compensate investors for this purchasing power uncertainty. This dynamic could be seen throughout the era of easy money, but it was pronounced in 2008 when the dollar weakened on the back of aggressive Fed rate cuts, sending inflation soaring. The yield curve responded by steepening significantly and rapidly pushing credit spreads wider, putting leveraged balance sheets under pressure. It is my belief that this spike in inflation risk was a major contributor to the financial crisis.
Now fast-forward to March 2011 during the Japanese earthquake and Fukushima nuclear disaster. At the time, QE II was again putting significant pressure on the value of the USD and, in turn, generating a material spike in US inflation rates. The brunt of this dollar weakness was seen in the USDJPY pair. When the earthquake struck, the yen rallied to new highs; to curtail this strength, the Bank of Japan intervened by selling yen to buy dollars, sending the USDJPY lower by 12% in just three weeks. This would mark a major shift in the BOJ’s policy initiative.
QE II continued into the spring and with it, dollar weakness and very high rates of inflation. By June, the YoY rate of PPI and CPI was rising to 7.0% and 3.6% respectively, which had a debilitating impact on US consumers. As such, the Fed opted to end QE II at its June 30 expiration date. The market events that followed can be described as utter chaos. There was a pervasive levered trade, short dollar, long QE reflation that came unwound in epic fashion, producing a minor stock market crash that invoked fears of another financial crisis.
During this period, the Bank of Japan would again intervene in currency markets to weaken the yen. On August 4, the BOJ sold $1 trillion yen and on October 31, they hit the market again with serious rhetoric: they were prepared to continue to sell yen until the "mission is completed." This commitment to weaken the yen in conjunction with the Fed's decision to opt for a balance sheet-neutral operation twist program would mark a major low in USDJPY.
After flushing the short dollar carry trades from the lows in September 2011 into Q1 2012, the dollar rallied 11.7% and with it the S&P rallied 15%. Both the USDJPY and US stocks consolidated these gains until the next major catalyst for the USDJPY. In September 2012, the Fed decided to launch QE III, and Shinzo Abe was elected head of the Japanese Liberal Democratic Party. The market understood this meant that Abe would become Prime Minister and began discounting his anti-deflation policy called “Abenomics.” QE was designed to weaken the dollar and Abenomics was designed to weaken the yen, but both can't be successful. As it turned out, Abenomics trumped QE III.
Between September 2012 and May 2013, the USDJPY rallied 34.5% and the S&P 500 20.0%. Over the same period as the bond market began to price in tapering, real interest rates rose and gold got annihilated. After hitting lows in June, gold subsequently lost 34.0% from its 2012 high. These are not random coincidences.
What's important to recognize about this period of risk performance is that equity multiples were purely a function of credit multiples. Since the 2011 low into the May 2013 high, credit outperformed equities. Credit spreads tightened more than the equity multiple expanded, thus the entire rally in stocks was a product of credit, which was a product of dollar strength.
The USDJPY spent most of the second half of 2013 consolidating these gains; gold bounced higher to sideways, while stocks and credit continued to grind higher. As it became evident the Fed was preparing to finally begin reducing stimulus in December 2013, the dollar embarked on another leg higher, with stocks and credit following suit while gold traded back to the June lows. This is where we stood last Tuesday as we closed out the year.
Consider where markets ended 2013. The 10YR closed at cycle highs at 3.0%, the USDJPY closed at cycle highs at 105.31, the S&P 500 closed at all-time highs at 1848, Investment Grade CDX spreads closed at cycle lows of 62bps, and gold finished at 1201 on the lows of the year. All of these markets are at extreme levels; all are products of falling inflation premiums in the face of the Fed using every tool in the tool kit to engineer inflation expectations. The takeaway from 2013 is that the Fed is not running this market like many presume.
Investors need to respect what the market price is saying regardless of Fed policy, and it all starts with the direction of USDJPY. This last leg higher in the USDJPY is almost the exact measured move as the initial move off the 2011 low, which could be a sign that a pattern is completing. In addition the RSI (relative strength index) has been in overbought territory on multiple time frames while diverging on new highs, which is also indicative of the end of a move.
The value of the USDJPY is the single most important market price to watch in 2014. The market is positioned for a tighter Fed and easier BOJ, but it’s not clear how much of the current trajectory is already priced in. The risk is a reversal of the recent trend, and the retrace could be significant with a range of market implications. On Friday, the CFTC’s commitment of traders shows that large speculators have significantly increased their net short position in JY futures to levels not seen since 2007. Whether the Fed is tapering or not, the conditions are in place for a major short squeeze adding more fuel to the fire.
Contrary to the belief that the Fed is manipulating markets, I see them acting quite rationally. Whether the Fed tapers or not, if the dollar weakens and gold rallies, risk multiples are going to suffer. I would not fade a coincident move lower in USDJPY and higher in gold. A lot of positions are leaning hard in the same direction and ripe for a reversal. If a weak dollar trade gains traction it could govern all markets for 2014.