Archbridge Capital Journal: November 2012

Sunday, November 25, 2012

"I think I'm turning Japanese"

Structural changes are supporting yen weakness:

Lower Savings rate means internal debt cannot be financed locally over time
Trade deficit means yen selling at the margin, structurally
Weak economic growth needs further large monetary and fiscal support

Structural weakness reduces yen as safe haven and increases its use as a funding currency

Treasury and BoJ aligned with focus on weaker yen and creating inflation

Buy US$ or AUD or NZD against Yen - expect multi-year rally, first target 90 US$-JPY

___________________________________________________________________________________

There have been strucural reasons for a weaker yen for some time:

The Japanese economy has been in dire straights for nearly a decade, with slow GDP growth, bigger debt issues than either Europe or the USA and very slow-reacting policy responses as well as chronic deflation. These factors have combined into Japan's Lost Decade and a half.

What has to date strucurally kept the yen from depreciating substantially has been the fact that government debt (which is around 200% of GDP) has been readily financed by Japanese investors.No external funds were needed. This was enabled by a very high savings rate due to a frugal population. Additionally Japan's trade surplus has for years aided the yen as it assured international demand for the currency.

Both these factors are diminishing rapidly and are in fact being reversed. The savings rate has over the last years fallen to as low as 0.5% and is currently holding just above 2% and is in line with the infamous spender: the USA. High savings rates existed due to an aging population that is used to saving, but with the bulk of this generation now reaching the end to their life cycle, gradually the 'saving generation' is being replaced by a new and not so frugal generation. The high savings rates of the past are unlikely to be repeated and even if they should be, it is unlikely that they will be recycled into financing Japan's government debt quite so readily.

Trade surpluses have turned into deficits assuring that not only the international demand for the yen is eliminated but that in fact net selling of the yen occurs strucurally on the margin. Japan has simply become too uncompeititve and her economy cannot function with these high levels of the yen.

Although the above structural changes have been in place for a while it was another development that has supported the yen in recent years and did not allow these slow moving structural changes to be reflected in the yen's valuation: This support came in the form of the financial crisis and the flight to quality that came with it. The yen rapidly became a safe haven currency for the region and each flight to quality has caused regional investors to flee to the 'safer' yen and her population to repatriate back home. This becomes obvious when correlating any crisis development of the past few years to the yen's movements or when looking at the net money inflows into Japan's money market funds over the last few years.

At last even this final trend is being reversed and replaced by catalysts which allow and even mandate a weaker yen: The Japanese population has finally had enough and is going to elect a new government (December 16th) whose main platform for running is a weaker yen as well as an end to deflation (with inflation targets as high as 3%). This new government will also appoint the next helm of the central bank as well as its deputies in April 2013. This means that they have all possible means of achieving their aims at their disposal and finally the Treasury and the Bank of Japan will be aligned in its mission to weaken the yen and create inflation.

This catalyst together with the above structural support should help the yen weaken for years into the future and one can reasonably expect 90 or higher for the yen-US$ rate within the next year.

Disclaimer: This posting is for information purposes only and is not intended as an offer,recommendation or solicitation to buy or sell, nor is it an official confirmation of terms. No representation or warranty is made that this information is complete or accurate. Any views or opinions expressed do not necessarily represent those of Archbridge Capital AG. This information is not intended, tax or legal advice. You also acknowledge that the information should not be construed as a solicitation or offer by Archbridge Capital AG to buy or sell any securities or any other financial instruments or provide any investment advice or service. Unless otherwise stated, any pricing information given in this posting is indicative only, is subject to changes and does not constitute an offer to deal at any price quoted. You should be aware that returns can be volatile and you may lose all or a portion of your investment. Past performance of any investment or trading tool is not necessarily indicative of future performance or results.

Thursday, November 15, 2012

A little Soya, Sir?

Soya spike was supply driven
Factors for the supply spike are not in place for next year
Expect contango: soya spike caused curve to steepen - this will get priced out over time
Though the spreads have already moved a lot there is more to come

________________________________________________________________________________

The soya market seemed to be overextended when looked at basic principles of commodities: if there is a price spike due to demand pull factors then this leads to sustained rallies, but supply shocks typically are short-lived. Since the latest rally in soya driving prices to about 1800 was caused by a supply shock in the form of a drought we thought it wise to analyse what chances there are of a repeat event next year. Let us first note that the drought that caused these rallies occured both in the US and in Latin America in the same year. This is a very rare event indeed. Here are the numbers: Our analsysis is based on general drought condition measured by percipitation and some other factors. The main result is that the probability of a repeat event like this year is below 7% for next year.

Given that world economic growth is not going to be staggering with Euroland having negative to flat growth, the USA perhaps 1.5-2% (given a base case outcome to the fiscal cliff issue) and China growing around 7.5-8.5% (ie similar to this year). We can expect demand growth to stay constant or be slightly reduced from this year.

Looking at the supply side we see that a) Latin America even in its most bearish case will have more production than this year. In fact normal (that is to say average) weather would create a crop of nearly 22% more than in early 2012. Given the unlikely event of drought being avoided in the next 12 months probably in both the USA and Latin America, with higher production rates in both regions we should see substantail supply increases without demand offset. And this does not even take into consideration the acreage re-allocation that takes place whenever a commodity experiences a price spike (higher prices tend to cure higher prices by increasing supply and reducing demand). One has to expect that this year's supply issues will be avoided.

Given the above we can expect soya prices to be substantially deflated from current levels. However, due to the volatile nature of softs one may prefer to express such a view in the safest possible area where vol is much lower and risk-reward profiles look better. One may do this by selling spreads within next years crop season.

Looking at the curve structure one can notice that some areas of the curve that fall within the same harvest period were too steep, trading in backwardation as the front rally for this year had influenced the forward curve for next year. One might reasonably expect the curve to fall into contango and hence expect spreads like the july - nov 2013 to narrow further.

Wednesday, November 14, 2012

Easy money? Where? (FX & Gold)

Though with pendulum action, the euro will strengthen (entries below 1.25 are must-haves) as liquidity reduces default risk

The additional liquidity and stability after the fiscal cliff decision will mean current elevated risk will be priced out, putting downward pressure on both the US$ and Yen (QE effect and US economic recovery will dominate over time)

China hard-landing will be priced out and with it Aud will be beneficiary

Stable economic growth in the USA (though at low levels) will also mean lower risk premia for the markets

Overall buying the euro in around the 1.25 region will be profitable and low 1.20's very much so

Gold will move in inverse to US$ but may take a long while to fully materialise its potential

Overall expectation must be above stated trends with decent pendulum action around those trends

_____________________________________________________________________________________

We are faced with pendulum action in euroland for a while now, when a crisis situation develops more funds are needed by a periphery country and decision-makers take their sweet time to come to a resolution. The equity markets fall, the german bonds rally, the rate spreads to periphery countries widen and the euro falls as investors flee to safety into the US$ and yen.

And so it is this time around, with spain having a stand-off with Draghi. Spain insists to not ask for funds until they know the preferrential rate they will be getting and the ECB is not willing to disclose this at the moment. Although we expect sooner or later Spain to run under the ESM's umbrella. Really does ESM not stand for Extra Spanish Money?

The important aspect to understand is that liquidity injections in the eurozone work in reverse to the USA. In the eurozone the key issue for weakness of equities and the euro is default risk, which rears its ugly head when politicians or the ECB dither. But any liquidity increase is not to be seen as inflationary nor as a weakener for the euro but instead helps to reduce default risk and strengthen the euro. With more than 1.5tr$ at risk for the whole euro-area if Greece defaults and surely much much more due to the contagion threat (Spain and Portugal will then follow) we have to assume that euroland will muddle through and the pendulum will continue swinging but over time default risk will increasingly be priced out of the market, hence the euro in the low 20's is a good buying opportunity.

Also please note that unlike the USA in the EU access to bank loans are continuing to deteriorate. The sept-oct survey found that 22% reported tighter availability of credit. Enough said.

In the USA QE and the expansion of the balance sheet have assured more liquidity into the system and banks are indeed lending more of the assets in their balance sheet, so that the real economy is indeed given an underlying boost. This is the single most important aspect for the longer term sustainability of US growth - ie that the transmission mechanism is working again. Commercial and industrial lending has climbed 23% from a year ago.

QE has helped over time to keep bond yields lower and inject liquidity to such an extent that the transmission mechanism is working again. To achieve this, however, the Fed's balance sheet had to grow substantially and in terms of how much more could be achieved and how - the answer is roughly the same again could be doable, but it would mean intervention into the municiple bond markets rather than mortgages and outright bonds. Realistically, however, each new QE had an increasingly muted effect and looking at multipliers we have to assume that for a long while we have come to a realistic end of QE, with the only possible exception of not letting any of the current programmes roll off (operation twist is scheduled to roll off at the end of this year).

In the USA any liquidity injection is a weakening force to the US$ - the opposite of euroland, as the USA has no default risk and has managed to sustain its reserve currency and bond status.

This means that the market from a future liquidity and growth perspective is dependent on fiscal policy. And the fiscal cliff is the core issue there, which is worth around 600bnUS$ or around 4% of GDP. Base case scenario must be that around 1-2% of GDP will be cut from the US growth rate next year on any compromise solution. This will prevent any US$ weakening until the fiscal cliff issue is resolved.

Interest rate differentials at these low levels are not key drivers of FX rates.

Hence US growth rates will be around 1.5-2% next year, Euroland negative 1% or flat and China steady at 7% - 8%.

Monday, November 5, 2012

The markets are too scared to discount

The markets are known for their ability to discount future events, however, current market events are of such a binomial nature and economic worries have large trading desks so scared that the market has nearly lost his ability...at least for now. The main culprit of this is the looming fiscal cliff, which if left unattended will mean that on December 31st the US economy will face a fiscal burden via tax increases and spending cuts in the region of 600bn US$ which translated into GDP growth is a staggering 4%. Given that growth rates in the USA will only amount to some 2+% in 2013.

There are a few mitigating circumstances that need to be considered: There is wealth effect from the equity rally and the housing market which amounts to a staggering 5tr US$ - however of this statistically only a few percentage points translate into actual spending (1.6% of GDP) and are just not enough to off-set the fiscal headwinds. In fact the USA would dip straight into recession if these headwinds are not controlled.

If Obama wins the odds are bad that he will be able to agree with the House and Senate before the deadline. Romney stands a much better chance of doing this. From a pure economic, US standpoint Romney's policies should drive equities higher within the first 60 days by around 4%, while the Obama result would probably help in the first instance as the uncertainty is priced out, but giving us an unclear picture thereafter due to the fiscal issues the country faces.

Given this market scenario our positions reflect the uncertainty and we are involved mainly in relative value positions which are isolated from delta movements and binomial outcomes. The only part where we have small exposure on pure delta plays is the jpy which we believe to fall over longer periods time.

Please note that we will be giving actual trades from time to time and that these are merely reflections of what we hold and are no attempt at solicitation nor anything more than information.