USD, Asian Equities, Emerging Markets and the JPY

There is a positive tone in Asian equity markets as USDJPY has marched through the key 110 level and won’t find any resistance before 111.45. The USD’s upside momentum is likely staying in place with the real yield differentials still leaving USDJPY about 3.5% under-priced. Yesterday it was the release of US second tier data and Fed’s Yellen suggesting that a rate hike could be imminent pushing US bond yields higher towards the 2.33% seen for 10y this morning. US 10y real yields have risen and are now at levels seen in March. The sustainability of the risk rally in this environment may depend on whether real yields are rising too fast relative to the improved earnings outlook (from expected fiscal stimulus).

Since 2006, the average bond duration held in benchmark portfolios has increased from 6 to 8 eight years (figure as of 2 weeks ago) and with market maker (banks) inventory books smaller due to regulation, portfolio adjustment pressures have the potential to increase real yields. In this case, the USD rally would turn less risk friendly. Globally, bond market valuations have lost USD1.5trn from their peak launching a dose of tightening of financial conditions. Looking at Bloomberg’s measure of financial conditions, we note that AxJ has particularly tightened, with a limited impact on the US or Eurozone for now. For us the price of capital is only one component to look at. The other component is the availability of capital best expressed by the money multiplier, which has increased in the US. This leaves our focus as the evolution of US real yields. Should portfolio liquidation pressures increase real yields early then the selling into high yielding EM will intensify.

Coming back to the JPY, Japan’s Aso calling recent market moves a ‘normalisation’ suggests there is more room for JPY depreciation. Concretely, Japan needs a higher money multiplier which requires banks to use their balance sheets more actively, which itself is a function of bank profitability. Japanese interbank lending volumes have doubled since their April low but are still only a mere 37% of the volume lent in January, suggesting there is room for improvement, weakening the JPY. The stabilisation, slope and volatility managed yield curve does help, but given Japan’s high debt levels the yield curve cannot do the entire heavy lifting of enhancing bank profitability. The help of a weak exchange rate is required. Japan’s authorities may act and communicate accordingly.