The OPEC agreement, Emerging Markets rally and the JPY




The OPEC agreement reducing output to 32.5-33m barrels a day, suggesting a production cut of 240-740k b/d,has sent oil prices 6% higher and our call seeing NOK, RUB and COP breaking igher is bearing fruit, but there are also implications for other currencies to draw, with the impact of higher oil prices on yield curves working as the catalyst. First,higher oil prices helps our call projecting a weaker JPY, second it boosts European currencies relative to JPY and USD and third it boosts the EM high yield trade for now, but plants the seed for USD breaking higher later this year and into 2017
US benefiting most: It seems Saudi Arabia has corrected its policy of ‘pricing out’ shale oil production. Shale oil production costs have deflated at a steep rate when innovative technologies were applied. Hence countries and companies linked to shale oil production should benefit most, suggesting risk appetite receiving a boost. Shale oil sector investment could also increase, which should work in favour of the US economy. The US economy seems to have closed its output gap, explaining why its core CPI has remained resilient despite the recent steep fall in import prices. Rising US oil sector investment may improve the economic outlook further and higher input prices should lend additional support to core CPI. Important too will be the impact on US foreign balances. With OPEC retreating from its maximal oil output strategy, the US may turn into the globe’s biggest oil producer for good, supporting its trade and current account balances. US capital import needs may decline, which ultimately would work in favour of USD.

EM rally: However, markets work in steps. Rising oil prices may develop spillover effects into other commodity markets, which would help commodity-exporting EM countries. Hence the high yield EM rally should continue for now. Working in the same direction is that it has been petro-dollar-related inflows boosting currency reserves in EM economies from 2009-12. Some market participants may assume that yesterday’s OPEC agreement may lay the foundation for a repeat of what happened seven years ago. Here we disagree. Many oil-producing countries struggle with twin or at least fiscal deficits, suggesting that this time petrodollars may be urgently required domestically.

The USDJPY rally: Hence, the EM high yield rally may find its limitations later this year. Better US oil sector investment combined with a likelihood that some DM countries may have closed or are in the process of closing their output gaps should stabilise yield curves (via higher growth and inflation expectations), which should work in favour of USDJPY and EURJPY. Sure, USDJPY has not yet exceeded the 102.50 resistance, which would confirm that a bottom has been traded, but higher oil prices have at least increased the probability of USDJPY breaking higher from here. This morning’s release of the MoF’s weekly security flow statistics illustrated a radical shift not boding well for JPY bulls. Foreign accounts have sold JPY-denominated debt at a record rate of JPY2.804trn in a week, while at the same time Japan invested a solid JPY1.178trn in foreign bonds. A similar sized liquidation of JGB holdings by foreign accounts occurred in March 2008, making the bottom of JPY yields. The following few months did see USDJPY gaining 12 big figures, rallying from 95 to 107. Japanese banks have increased their long-end (10y+) mortgage lending rates despite seeing money market rates falling, suggesting that monetary velocity is in decline. Japan’s authorities should be electrified by this development as it happened with Japan’s real estate prices falling. This finding supports our view that Japan’s authorities need to take measures to support the financial sector profitability to allow monetary velocity to rebound.