Amidst a Red-Hot Japanese Equity Market, Are Banks a Short?

Abenomics has taken the investment world by storm. While Abenomics, and particularly BoJ chief Kuroda's conventional central bank policy "blasphemy" makes investors nervous, this hasn't hindered Japanese equity performance from trashing essentially any other equity market or asset class year-to-date.

Hat Tip: Business Insider

Bank Stocks are Noticeable Laggards

Japan’s three megabanks, however, have significantly lagged this surge, as investors first piled into reflation stories like real estate (including “hidden” real estate assets) and later the big exporters as the substantial weaker yen windfalls began showing up in earnings and company forecasts.

Source: Yahoo.co.jp

In USD terms, Mitsubishi UFJ FG's ADR is performing somewhere between best-of-class JP Morgan (JPM) and 2008 financial crisis basket case Citigroup (C). 

Source: StockCharts.com

Japan’s Three Megabanks are Cheap, But.. 

Japan’s major banks largely dodged the US housing debacle, and have relatively strong balance sheets while profits in FY2012 were apparently good. Yet they are still selling below book value and well below market P/E multiples. Does this mean Japan bank stocks are due to catch up to soaring market benchmarks? 

In FY2012, the big three logged strong results due to brisk earnings from overseas operations that, together with income from market products, more than offset slumping domestic lending services. But despite relatively strong balance sheet health, they have yet to improve their profitability. Interest margins last fiscal year were unexpectedly low because they chose to play it safe by extending loans to Japanese companies and blue-chip local firms. They provided virtually no funds to local venture businesses, where the profit margins are high. 

The megabanks also remained weak in commissions-based businesses that help stabilize earnings without draining capital, while this is changing because of Abenomics. Sales of equity and real estate investment trusts risen since Abe's government took power in December have soared. For fiscal 2012, combined sales reached JPY5.4 trillion, up 20% YoY. Three out of five lender groups, including Mizuho Financial Group Inc., posted record-high annual group sales of investment trusts. 

To offset a domestic lending margin squeeze that is being exacerbated by massive BoJ quantitative easing, Japan’s banking majors are for example hiring Spanish-speaking bankers to win new business in Latin America and giving loans to junk-grade borrowers in the United States to offset meager returns at home. They are also looking to increase lending denominated in local currencies, instead of the usual dollar-dominated loans. 

Kuroda’s No Holds Barred Monetary Policy is Squeezing Bank Profits 

While there are signs of recovery in loan demand from domestic companies, but the profits earned by the banks on their loan portfolios will fall if interest rates keep falling. 

The three megabanks led by Sumitomo Mitsui Financial Group (8316) forecast earnings will decline 27% to JPY580 billion this year as monetary easing makes loans less profitable even as borrowing picks up amid an economic recovery. Mitsubishi UFJ Financial Group (8306)’s if forecasting an 11% decline to JPY760 billion yen and Mizuho Financial Group (8411)’s also expects an 11% drop to 500 billion yen. 

Black Swan Risk Discount 

Further, there is one big black swan risk that investors cannot ignore. The massive volatility in the JGB market could punch a big hole in still substantial bank holdings of government debt. Virtually all of Japan’s banks have been earning healthy profits by purchasing JGBs, but these profits are now at risk. 

Banks’ large and increasing holdings of JGBs are a key source of vulnerability. With outstanding JGB holdings in Japanese banks (excluding Japan Post Bank) more than 30% commercial bank assets in Japan, the IMF warned in August 2012 that “JGB market exposures represent one of the central macro-financial risk factors”, where a 100bps (1% point) back-up in bond yields means 10% and 20% mark-to-market losses for regional and major banks respectively, which the current JGB move is rapidly approaching. In other words, a 100bps interest rate shock in the JGB yield curve would cause a JPY10 trillion loss for Japan's banks, according to JP Morgan estimates. Regional and Shinkin banks are smaller than major banks, but they together hold a large JPY50 trillion of JGBs versus JPY120tr of JGB holdings for major banks. If Kuroda does deliver on his 2% inflation target, Japan's banks stand to lose some JPY20 trillion on their government bond holdings as JGB yields rise to the sustainable inflation rate. 

Hat Tip: Zero Hedge

Further, in terms of sensitivity to JGB interest rate shocks, Japanese banks appear to be more vulnerable than they were in 2003, when a sudden reversal in 10yr JGB yields from 0.5% in June 2003 to 1.6% was caused by banks scrambling to control their value at risk (VAR). Then, the bond selloff was aided and abetted by a rise in Japanese stocks, as investors piled out of one market and into the other, similar to conditions today. Now, a 100bps adverse move in JGBs would cause a loss of JPY3 trillion loss for major banks, but a JPY5 trillion loss for regional banks and JPY2 trillion loss for Shinkin banks, or a hit to Tier 1 capital of some 35% for regional and shikin banks versus only 10% for the major banks. The hit this time will be larger than in 2003, where the expected theoretical loss from a 100bps rate shock was around JPY2 trillion for major banks, JPY3 trillion for regional banks and JPY1 trillion for Shinkin banks, or significantly lower than estimated currently.

As the shorter-term chart below shows, the direction of JGB yields has clearly reversed. But does this mean a) the BoJ has already lost control of bond yields BEFORE they really get started in their shock and awe easing campaign, b) this is the beginning of the long-awaited (by the Japan bears), JGB crash?

Source: BarChart.com

The long-term chart of 10yr and 5yr JGB yields puts this short-term move into perspective. In our humble opinion, people are making a bit of a mountain out of a mole hill. Firstly, the high volatility and sharp short-term backup in yields comes after an historical drop-off in bond yields that represented the final leg of a two-decade implosion of JGB yields from over 8%.

During this period, bond yields have periodically punched lower, followed by a sharp "dead cat bounce" as overly bullish bond trading positions were covered. Similar snap-backs can be seen in 1994, 1999 and 2003. 1994/1995 was the first dramatic break-up in JPY/USD to below JPY80/USD, The 1999 bounce came amidst the second round of bank capital injections and negative growth in 1998, prompting the BoJ to introduce its ZIRP (zero interest rate policy) for the first time. While a VAR "shock" was the ostensible reason for the sharp reversal in JGB yields in 2003, the bounce came as investors realized Japan's banking and bad debt crisis was ending and stock prices began to soar. But for all of the excitement about Junichiro Koizumi's bank clean-up and "no growth without reforms" recovery (i.e., talk of "Japan is back"), bond yields never breached 2% as the basic deflationary factors were never completely eradicated. 

In light of this 20-year history--including the 2003 VAR shock--the recent move in yields from a longer-term perspective is but a tempest in a tea pot, bank balance sheet sensitivity notwithstanding. 

Thus while bank stocks are lagging in (rightly) allowing for black swan tail risk in their substantial JGB holdings, JGB yields themselves are far from spiraling out of the BoJ's control. 

Source: JPM, Hat Tip: FT Alphaville

Bottom line, we expect this "black swan" discount as well as the squeeze on bank loan spreads from an aggressive BoJ to continue hobbling a more significant relative move in Japanese bank stocks. On the other hand, the strong "tide lifts all boats" momentum of underweight foreign pensions and renewedly bullish domestic and foreign fund investors should also keep the bank stocks bouyant if not outperforming the Nikkei 225. 

Its US and Japan Stocks versus Commodities, China Stocks and Bonds

US Stocks Continue to Grind Higher

Despite warnings of “too far, too fast” and “running on fumes”, US stock prices continue to grind higher. In the charts, there are signs of confirmed upside breakouts everywhere. Concerns about 

yet another summer swoon are being dispelled by better-than-expected employment and retail sales, as well as ongoing evidence of recovery in the housing market. 

Further, rather than “going to hell in a hand basket”, the U.S. debt situation is actually improving, and at a significant rate, according to projections by the Congressional Budget Office (CBO). “If the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $642 billion, the smallest shortfall since 2008. Relative to the size of the economy, the deficit this year—at 4.0 percent of gross domestic product (GDP)—will be less than half as large as the shortfall in 2009, which was 10.1 percent of GDP.”

Source: 4-Traders.com

Source: Yahoo.com

Long In the Tooth? 

As for claims that the US bull market is long in the tooth, market history shows that the current recovery at just under 4 years is not that long versus historical US bull markets. 

Hat Tip: BigPicture.com

Soaring U.S. Equity Risk Premium 

Based on traditional measures of the Equity Risk Premium (ERP) stocks are about as cheap as they've been in 50 years, a function somewhat of ultra-low bond yields. The Liberty Street Economics blog (hosted by the NY Fed) combed academic literature, economists at central banks for their models, most of which predict historically high excess returns for the S&P 500 over the next five years. 

Interim market corrections are inevitable, even in historic bull markets. The lack of any suggestion of "sell in May and go away" can be attributable to, a) no flare-up in the Eurocrisis. Indeed, Southern Europe sovereign bond yields have fallen rapidly and Greece was even upgraded recently by Fitch, b) the Fed's open-ended QE commitment. In the previous corrections, an approaching end to QE was making investors nervous, c) the ECB and BoJ being fully on board with "whatever it takes" QE, and d) signs of a slow but steady recovery in economic conditions. 

Hat Tip: Business Insider

Eurozone in Longest-Ever Slump 

Eurostat flash estimates show GDP fell by 0.2% annualized in the Eurozone versus an expected 0.1% decline, but compared to -0.6% growth in Q4 2012. YoY, the decline was 1.0%. In core Euroland, France, Italy, Spain GDP were contracting, while Germany was growing at only 0.1%. This is now the Eurozone’s longest-ever slump. 

The good news is that the “crisis premium” has shrunken significantly, judging from 10-year sovereign bond yields. Greece even received a credit upgrade from Fitch. Spain and Italy 10-year sovereign yields have plunged from crisis peaks near 7% to 4.3% and under 4%, respectively. Further, while the economic news from the Eurozone is bad, these economies are not exactly in free-fall. 

Source: JapanInvestor

Eurozone Bank Stocks Still in the Penalty Box 

Yet the Eurozone is far from having solved its problems. The anemic bounce in the Euro Stoxx Banks index indicates there are still substantial balance sheet issues that Eurozone banks need to deal with. According to Ernst & Young, Eurozone banks are just two-thirds of the way through deleveraging; Euro132 billion of further loan-book shrinkage expected in 2013, and non-performing loans are expected to hit a Euro-era high of 7.6% in 2013. The consumer lending squeeze continues, while business lending forecasts highlight the north-south divide. 

Given the above, don’t expect a full-fledged recovery in Eurozone bank stocks anytime soon. 

Source: 4-Traders.com

Slowing Growth in China a Big Weight on Global Industrial Commodities 

Further, China's economy continues to disappoint. It seems the incoming data from China are dampening hopes of renewed acceleration in China’s economy. 

Hat Tip: FT Alphaville

The Growing Disconnect Between Bouyant Stock Markets and Falling Commodity Prices 

Ostensibly, commodity prices are falling because, a) a weak global economic recovery versus “whatever it takes” monetary stimulus, b) the supply shock created by a surge in North American oil production, c) the commodity-intensive part of China’s growth story is waning and the Eurozone is in recession, d) increasing commodity supply capacity. If there is a link between commodity prices and inflation, waning commodity prices are deflating inflationary expectations, which in turn is affecting “investment” demand for commodities. 

The Great Abenomics Experiment Appears to Gain Economic Traction

Japan's Q1 GDP growth beat expectations by growing 3.5% annualized, which was the quickest pace in a year and the best growth number in the G7. Individual spending is picking up as the value of assets, including stocks, rises on the back of the brighter economic outlook. Exports are also recovering. Economists, other observers have turned their attention to PM Abe’s growth strategy, seen as the key to boosting business investment. Abe is scheduled to reveal the third arrow, structural reform, of his three arrow revival plan next month.

But the jury is still out on BoJ governor Kuroda’s 2% inflation target. In Q1, the so-called GDP deflator, a broad measure of prices across the economy, tumbled 1.2 % YoY, the most since the final three months of 2011, underscoring Kuroda’s challenge in eradicating deeply entrenched, chronic deflation in Japan.  The BoJ’s heavy intervention in the bond market has caused a great deal of volatility in bond prices, but with 10-year yields still at a mere 0.86%, the economic impact of a backup in yields, although sharp, is miniscule.

While domestic investors in the main are skeptical of soaring stock prices, now the highest since early 2008 before the global financial crisis, the sharp drop in JPY exchange rates as well as a noticeable improvement in consumer confidence is providing fundamental support for sharp upward revisions in corporate profits. Bloomberg data indicate the 201 companies reporting so far for the quarter through March have seen a 51% YoY surge.

Extreme Moves in JPY and Nikkei 225 Will Inevitably Abate, But That Doesn't Mean its Over

Given the steep drop-off in JPY versus USD and an equally parabolic move in the Nikkei 225, it would be foolhardy to expect Japanese stock prices to continue rallying at the current torrid pace, and interim corrections are inevitable. For the time being, however, the working assumption is that both the JPY and Nikkei 225 reversals are sustainable for the foreseeable future.

The following chart from Nomura illustrates just how closely correlated the selloff in JPY is with the rally in the Nikkei 225. Other factors at work on stock prices include the BOJ’s decision to be more proactive in purchasing ETFs as part of its asset purchase program, another is the widespread expectation among institutional investors that the Abenomics growth strategies (the third arrow) to be announced around June 14 will be favorable for Japanese equities. The buzzwords high on the list of countermeasures investors would like to hear include, deregulation, easier migration, greater job mobility, corporate tax breaks, efficient  utilization of financial assets, special economic zones, and wage increases. 

Hat Tip: FT Alphaville

Abenomics has transformed the Nikkei 225 from an after thought among global investors to the hottest-performing market in the world since Nobember of last year. During this period, it has soared past the performance of the US and Germany, and is trashing its Asian rivals, including the struggling Shanghai Composite and South Korean KOSPI indices. 

As a result, investors with global/international portfolios are still scrambling to get at least a neutral weighting for Japan in their portfolios. Ironically, domestic financial institutions wedded to hard-and-fast asset allocation rules have been dumping Japanese equities almost as fast as foreign investors have been buying…thereby ensuring mediocre performance vis-à-vis their foreign competitors, and they stand to lose more on their significant bond holdings given a more substantial back-up in JGB yields. 

On the other hand, individual investors have also caught Abenomics fever, piling into domestic investment trusts to the point that some of these funds have closed to new capital. The unrealized capital gains on existing holdings of course is a big factor stimulating sales of luxury goods.

Source: Yahoo.com

With the BoJ and the Japanese government in full court press to reflate Japan, we see the rally in the Nikkei 225 continuing for the foreseeable future, as long as a) JPY continues to weaken against its major trading partners, b) the now highly volatile JGB market does not "blow up". As previously mentioned, investors are now looking toward the third arrow of Abenomics, which is the growth measures, ostensibly including structural reform. Structural reform is where the Koizumi boom ran into some serious flack from entrenched interests, and investors will continue to monitor how much progress Abenomics can actually make on this front, even after the mid-year elections solidify Abe's and the LDP's political base even further. 

Topix Sector Rotation

The red-hot real estate sector is beginning to take a breather after driving the Nikkei 225 and Topix higher for the past five months, as are the broker/dealers. While the banking sector is enjoying a major revival in unrealized profits on their portfolio holdings, Kuroda's aggressive monetary policy is squeezing margins on their loan business, leading to weak earnings reports. Thus Japan's banks are being hurt, not helped, by Abenomics, at least for the foreseeable future. Substantial holdings of JGBs of course would also be hit hard by a major back-up on volatile bond yields, although the mega banks have been running risk simulations for some time. 

Source: Tokyo Stock Exchange

Deflationists are Forecasting Something that Happened Five Years Ago

Just How Much “Fundamental” Support is there for Stock Prices? 

Academics who have analyzed the historical relationship between GDP growth and stock price performance across developed and developing country markets find a very tenuous correlation between GDP and aggregate stock prices that is typically quite low and even negative. O’Shaughnessy Asset Management is among others who say the correlation between aggregate GDP and stock prices is non-existent… EXCEPT that you would historically earned a 21% one-year return if you invested when GDP is less than zero percent! By the same token, investing when consumer confidence is below normal produces average five year annualized returns of 11.5%, but the correlation is zero looking one year out. 

However, a significant relationship can be found between equity returns and expected GDP growth. By the same token, market returns are unrelated to past earnings, but are influenced by changes in expected returns, expected cash flows and expected discount rates. Callagn, Murphy, Parkash and Qian (Journal of Investing, 2009) show stock prices to be a function of long-term earnings forecasts, while stock prices reflect not only the average of the IBES long-term earnings predictions but also some superior forecasting power beyond that aggregated average prediction. 

The bottom line therefore is that stock prices are driven by changes in investor expectations and perceptions of future “fundamentals” (e.g., GDP growth, earnings, discount rates). These changes are hard if not impossible to objectively measure. 

Market Conditions Now are not “Normal” 

Despite the dire warnings of debt deflation cassandras, realistic investors must accept that the Keynesians and monetarists, who generally foresee a 1930s-style slump unless the economy is stimulated out of it, are in charge. Rather than repeatedly pounding the table about the errors of Keynesian/monetarist ways, investors must accept that the world’s central banks will continue pumping dump truck loads of fiat money to ensure their economies do not fall into a deflationary spiral. Basically, the deflationists are forecasting an event that happened five years ago, when the worst fears of a 1930s-style slump was disproved by massive monetary intervention. 

This does not mean the post 2008 slump is over: far from it. But it is more realistic to assume the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented.　On the other hand, the massive central bank debt monetization IS eroding confidence in government and ultimately its paper fiat money, and this, we believe, is behind the world-wide rush into physical gold despite the crash in paper gold prices.

Source: 4-Traders.com

No Sell in May and Go Away this Year? 

The news flow about economic growth is not as good as investors were expecting a couple of months ago. Risk markets reacted negatively to the generally weak April global PMIs (purchasing manager indices), particularly those for Germany and China. Instead of triggering a selloff, however, bad PMIs, particularly Eurozone composite PMI where a sub-50 reading indicated a recessionary a drop in activity for the nineteenth time in the past 20 months, only led investors to expect further monetary easing in the Eurozone. 

                            

US business cycle and survey-based surprise indicators have plunged. Further, the lower highs being made in these indicators of the business cycle suggest the spillover effects of QE are also disappointing.

Source: Bloomberg, Hat-Tip: Zero Hedge

Yet Stock Prices Continue to Grid Higher 

Yet investor confidence that the Fed, ECB and the BoJ “have their back” remains strong, despite ample evidence that central banks are still largely pushing on a string in getting massive monetary base money to circulate into the “real” economy, as evidenced by the money multiplier and velocity of money. As we have repeatedly argued, quantitative easing can help keep financial systems/banks afloat in the immediate aftermath of a financial crisis by backstopping bank balance sheets and acting as the lender of last resort. But in a liquidity trap, not only can the Fed not control the money supply (M2) and the money multiplier, it can't control the velocity of money either. And that means the Fed alone can't create rising aggregate demand as long as the transfer mechanism (money multiplier) between the monetary base and M2 remains broken/dysfunctional. In this regard, the notion that the Federal Reserve is “printing money” is false, at least as regards “real” as opposed to “monetary” money supply. While the Fed expanded the monetary base (currency (notes & coins) in circulation + commercial bank deposits at the central bank) from $840 billion to $2.93 trillion (+249%), year- over- year expansion of M2 is recently only 6.8%...Ergo, the empirical evidence is clear that high- powered money is not causing a corresponding increase in “real economy” money.

Source: FRED

While a 1930s-Style Debt Deflation Has Been Averted, Has a Japan-Like Malaise Also Been Averted? 

Given massive central bank intervention, the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented. But the jury is still out whether a Japan-like decades-long malaise has also been prevented.

Source: Bank of Japan

Inflation Expectations are Still Falling 

The great rotation from bonds into stocks that was all the rage just a couple of months ago is not. The St. Louis Fed’s 10-year inflation forecast based on the yield spread in 10yr treasuries (nominal) less inflation-indexed notes shows a sharp drop-off, leading to lower, not higher bond yields. The much feared monetary tsunami-inflation link has yet to be seen.

Hat Tip: Capital Spectator

But Government Sector Intervention IS Supporting Positive Total Credit Growth 

Yet while central banks continue pushing on the perverbial string, the U.S. economy IS growing, albeit anemically. The following chart tracks the YoY change in total credit creation in the US. During and after the financial crisis, credit provided by the financial sector plunged, and is still declining YoY. If this were the only source of credit, the US economy would still be in recession. Fortunately, the credit “hole” in the financial sector was plugged by the government sector, allowing positive, but tepid, growth to continue.

Source: FRED

The Fed has been able to influence risk appetite and inflation expectations with QE, and by goosing risk asset prices, has supported the economy through its own version of “trickle down”. On the other hand, total credit IS growing. Thus instead of looking at the monetary base and the money supply, investors should follow the trend in total credit creation as the gauge of real support for the economy.

Source: FRED

Is the S&P 500 and US Stocks on the Verge of a 1970's Breakout Moment? 

As previously mentioned, stock prices continue to grind higher, to pre 2008 crisis levels. The central bank “puts” undoubtedly have set a floor under downside risk, but is this the only factor driving stock prices? We suspect not. Since the 2009 low, the bears have been consistently wrong. In other words, the stock market is acting like it`s in a secular bull, not bear market. As Ralph Acampora states, “the low, in March of 2009, was a generational low. Part one of a secular bull market, this period that we're in, is led by investor disbelief and fear.” 

Firstly, as mentioned, there is the renewed growth in total credit. While the degree of recovery is debatable, the surge in housing stocks, the expectation is that housing is on the mend and again positively contributing to growth instead of detracting from it. In addition, Exxon says the energy renaissance in the U.S. will continue and predicts that North America will become a net exporter of oil and gas by the middle of the next decade. The U.S. Energy Information Administration (EIA) reckons that imported liquid fuels as a share of total U.S. liquid fuel use reached 60% in 2005, dipped below 50% in 2010 and fell further to 45% in 2011, and should further decline to 34% in 2019, while the International Energy Agency (IEA) projects the U.S. could leapfrog Saudi Arabia and Russia to become the world’s biggest oil producer by 2020, and a net oil exporter by 2030. This represents a major watershed event for the U.S. economy. 

The U.S. stock market is already looking much stronger than past modern-era bear markets adjusted for inflation.

Hat Tip: DShort

When Will the Great Japan Trade Run Out of Gas? 

In case you haven’t been paying attention, the Japanese stock market is on an epic run. The Nikkei 225 is up 60% since last November when government officials began hinting at big policy changes that have since come to be known as “Abenomics”. As previously stated, academic research indicates that market returns are unrelated to past earnings/economic performance, which is what most of the economic data and earnings announcements represent, i.e., past performance. The real drivers of stock prices are changes in expected returns, expected cash flows and expected discount rates. 

From the dramatic reaction in JPY exchange rates and Japan equity benchmark indices, you’d think that something had not just changed, but that we’re looking at a new economy entirely. Within the realm of investor expectations, that is exactly what has happened. Bloomberg’s William Pesek and other skeptics are asking “where is the beef?” in Abenomics and points to a disconnect between perception and reality. 

Unfortunately, Mr. Pesek and others don’t get the importance of expectations vis-à-vis reality, aka George Soro’s Theory of Reflexivity. In the modern “financial” economy, changing (this time entrenched) expectations is half the battle. 

In the long 20-year Mother of all Bear markets malaise, Japanese stocks have seen many virulent but brief surges in stock prices, as is shown in the chart below, in of the prior cases, however, the government and BoJ were never able to “permanently” change investor and business expectations, and the economy as well as financial markets repeatedly slipped back into lethargy and lower prices. Even the Koizumi reforms, which produced the best rebound (over 100% in total) to date, eventually fizzled.

Hat Tip: Pragmatic Capitalism

In its latest Japan survey, the OECD forecasts the Japanese economy will grow by about 1.5% annually in 2013 and 2014, and hails Prime Minister Shinzo Abe’s three-pronged strategy -- bold monetary policy, flexible fiscal policy and a growth strategy – as a plan to end 15 years of deflation and reviving economic growth. 

Yes, Japan’s gross public debt reached 220% of GDP in 2012, the highest level ever recorded in the OECD area, while the budget deficit is hovering around 10% of GDP, and “it remains critically important for Japan to address extremely high and still rising levels of government debt and other challenges posed by its ageing population,” as pointed out by the OECD Secretary-General Angel Gurría. The OECD also has also correctly emphasized that Japan needs to use regulatory reform to boost sustainable growth; particularly in the agriculture sector. The OECD believes Japan can create a more competitive agriculture sector by promoting consolidation of farmland to boost productivity, phasing out supply control measures, and shifting to less distorting forms of government support. Other potentially effective reforms include a) promotion of “green” growth and restructuring of the energy sector and b) increased women’s as well as older worker participation in the labor force to maximize its human resources. Reforming the tax and social security system, encouraging better work-life balance, and increasing the availability of affordable childcare would go a long way in this direction. 

Break Above 18,000 Would Represent a Real Change of Trend 

While the Nikkei 225 has already seen a parabolic move off historical lows, it would have to break up decisively through the Koizumi-era high of over 18,000 to represent a real change of direction from the market secular downtrend since the 1989 historical high.

Source: Big Charts, JapanInvestor

Japan “passers” such as Pragmatic Capitalism’s Cullen Roche initially dismissed the BoJ’s no-holds-barred QE as a ponzi scheme, but are now openly wondering, “what if monetary policy is much more powerful outside of a BSR (balance sheet recession) than we presume? By the same token, if the Abenomics bold experiment (which is basically the Fed’s playbook on steroids) actually works, what does that imply for the eventual outcome of the Fed’s monetary blasphemy? 

JPY is Far From All-Out Collapse Territory 

Axel Merk of Merk Investments as well as others (most notably Kyle Bass) insist that the BoJ’s monetary blasphemy and the governments “depression era” fiscal policy will render JPY “worthless”. We would counter that JPY is merely in the process of returning to a pre-financial crisis trading range. 

As seen in the chart below, the snap-back from a historical low versus USD in 1995 was just a rapid, but did not represent a secular trend change. As JPY/USD has yet to even reach prior highs in the late 1990s and early 2000, or even exceed the psychologically important JPY100/USD, it is way to early to declare JPY has permanently collapsed. 

Further, as Stephen Jen of SLJ Macro Partners has pointed out, it is Japanese investors, not global hedge funds, that will determine JPY eventual fate.

Source: 4-Traders.com

All that Japan really needed to revive its export competitiveness was a 30% currency depreciation, such as was enjoyed by its rival South Korea, whose exports and companies suddenly appeared unassailably competitive versus Japan following a 30% depreciation in the Won. 

Revived export competitiveness notwithstanding, investors are rushing into domestic reflation plays, with surging high beta broker/dealers and real estate stocks leading, and the export sectors to follow after global demand more clearly recovers.

Abenomics vs Koizumi Rally

Source: TSE, JapanInvestor

Time to Bail on the Hottest Trade (Short Yen, Long Nikkei) This Year?

Investors are Dumping Inflation Hedges

The noticeable shift in sentiment suggests the market may be approaching a breaking point where investors give up on the notion that the economic recovery is accelerating and/or that inflationary pressures are rising.

Since global financial stability slowing continues to improve (as confirmed by recent IMF statements), what we are talking here is not another look into the abyss, but a reality check, where “excessive” investor expectations for growth and inflation are again squeezed out of market prices. While “acute” global financial stability risks have been reduced, the Eurozone has an ongoing debt and credit problem that is suffocating economic growth and thus corporate and bank balance sheet repair in the region remains spotty and uneven, leaving a sword of economic and financial stability hanging over the region. The following are some yellow flags that markets (investors) are beginning to “smell” deflation.

Yellow Flag 1: Investors dumped their holdings of TIPs (Treasury Inflation-Protected Securities) last week following a weak auction of 5-year notes. Falling prices prompted a spike in yields on the TIPS, which ostensibly hedge against inflation. Traders observed that, “the rest of the TIPs market is having a mini implosion since the auction, as real yields on TIPs have jumped 8-10bps across the curve in what appears to be a ‘get me out’ trade. The spread between the yield on TIPS and the yield on plain vanilla Treasurys, or break-even rate, which dictates the rate of inflation necessary for TIPS to provide a better return, has been in free fall. Before the auction, the rate was at roughly 2.24%.

Yellow Flag 2: Commodity prices are selling off. While the financial media was focused on the first weakness then sharp selloff in gold, significant selling was also underway in other commodities more closely linked with the real economy. The CRB index has quickly sold off some 7.9% from a 2012 high and is still over 24% lower than its 2011 post-crisis high. Copper has recently sold off just under 14% and is 30% lower than its post-crisis high, while crude oil (Brent) has sold off over 11% and is also about 24% below its post-crisis high.

In the week ended April 9, investors unloaded the equivalent of about 20 million barrels of oil in U.S. petroleum contracts, according to the CFTC’s Commitments of Traders data. Bloomberg data indicate indicate hedge funds and other money managers cut their bullish bets on Brent to their lowest level in four months, while a separate survey by Bloomberg shows investors expecting US crude supplies to hit a 23-year high of over 390 mm/bbl.

Since bottoming in October 2012, inventory levels of copper have risen 190% in warehouses operated by the London Metals Exchange. That’s a huge and rapid increase, and it conveys a powerful message about the future for copper prices. We are seeing an even more rapid rise in inventory levels than when global demand collapsed in 2008, and it comes on just a small amount of drop in copper prices. 

Yellow Flag 3: Great rotation not. Despite all the talk of the “great rotation” from bonds to stocks, global bond yields have taken another leg downward, with the German 10yr bund recently falling 50bps to 1.25%, the 10yr US treasury dropping 38bps to 1.68% and of course Japan’s 10yr dropping 39bps to historical lows at 0.45%. Even Spain’s 10yr bond yield continues to decline, by a large 238bps to 4.64% from July 2012 highs. Falling bond yields of course are another hint of shrinking growth expectations and/or shrinking inflation expectations.

Yellow Flag 4: Emerging markets have been underperforming by a widening margin since late 2012, ostensibly because of softening economic data, weakening commodity prices and slowing capital flows.

The Gold Crash Whodunit

The $20 billion gold futures sale and concentrated selling of gold futures on the US COMEX on Friday and Monday has gold bugs shouting “conspiracy” as they smelled manipulative selling by a large hedge fund, bullion bank or even the Fed, behind the crash. The CFTC is scrutinizing whether gold prices are being manipulated, although they public state that the drop doesn't necessarily mean "anything nefarious". The CFTC said in March that it is looking at issues including whether the setting of prices for gold—and the smaller silver market — is transparent and if it is fixed.  Blackrock said it saw“no visible central bank activity” although the reported sale of (USD400 mm) gold by Cyprus was supposedly one trigger for the selloff.

Selling of paper gold ETFs backed by real gold probably accelerated the move. This is because GLD shares are dumped at a quicker pace than gold’s own selloff, creating an excess supply of GLD shares, forcing GLD administrators to buy up this excess supply, and raising cash to do this by selling gold bullion. According to Zeal LLC, the recent “correction” in GLD’s holdings forced it to dump a staggering 169.8 tons (5.5 million ounces) of gold bullion simply to keep GLD shares’ price tracking gold! There are only two gold-mining companies in the entire world (Barrick and Newmont) that produce that much gold in a whole year. The drop capped a trend of declining global gold investment (including bars, coins and ETPs), as the World Gold Council saw an 8.3% drop to 424.7 tons in 4^th QTR 2012.

George Soros and Louis Moore Bacon reportedly cut their stakes in gold ETF products last quarter, for Soros by 55% as of December 2012. Once heavily long gold, hedge funds reportedly cut bets on a gold rally by 56% since the yellow metal reached a 13-month high last October. As hedge funds headed for the exits, the investment banks turned bearish. SocGen declared the gold era was over and set an end 2013 target of USD1,375, near the time that Citigroup declared the end was nigh for global oil demand growth (on substitution natural gas for oil combined with increasing fuel economy).

Goldman set a year end target of USD1,450 and said it could go lower, then nailed the selloff with  a "short gold" recommendation a week before gold really tanked. This selling came amidst a consensus among economists that economic growth would accelerate in the U.S. and China in the coming quarters, according to Bloomberg and other surveys.

Gold has Lost its Safe Haven Status?

Soros total the South China Morning Post, "Gold has disappointed the public”…”when the Euro was close to collapsing in the last year...gold was destroyed as a safe haven, proved to be unsafe...Gold is very volatile on a day-to-day basis with no trend on a longer-term basis." While Soros was long gold big time until fairly recently, he called gold "the ultimate bubble" in February 2010, implying he would enjoy the momentum ride until the music stops.

It is puzzling that gold crashed just as the BoJ was unleashing its “shock and awe” monetary expansion that will double Japan’s monetary base from Y138tn or 29% of GDP at the end of 2012 to Y270tn or about 54% of GDP by the end of 2014. This compares to a US monetary base expansion of 6% GDP in mid-2008 to 19% of GDP by this March. The BoJ’s increase in balance sheet of Y5.2tn (US$54bn) per month in 2013 is the equivalent of annualised 13% of 2012 GDP, or roughly twice the Fed’s current balance sheet expansion, at annualized 6.5% of 2012 US GDP.

If the real reason for the gold crash ends up being “rogue” shorts by Goldman, Morgan Stanley or JPM, etc. traders swinging for the fences that eventually blows up in their face, we may have a more serious problem than realized.

Source: 4-Traders.com

Is the Recovery Bull Market Already Long in the Tooth?

Looking at every bull market in the US since 1871, the historical “average” bull market lasted 50 months, with a media gain of 123.8%. The range since 1970 however has been substantial, from 32 to 153 months in duration, and gains ranging from 56.6% to over 516%. There is of course no way of knowing whether this bull market will be a short one or a long one, but coming out of the 1930s depression, there were no less than four bull markets ranging from 140% to 413% gains. For our money, this bull market is reaching a historical median milestone has no particular significance. 

Hat Tip: Big Picture

Economic Surprise Index Turns Negative 

In addition to the disappearing inflation premium in TIPs, we believe the negative turn in Citigroup’s Economic Surprise Index is having an impact…i.e., investor expectations were overshooting what it now appears the recovery is able to deliver. This is a marked contrast from the June 2012 to November 2012 period, when investor expectations were low and the economic data was surprising on the upside despite investor concern about the Eurozone and the US budget impasse. Given that US sequestration has kicked in, know one should really be surprised that the US economic data is looking “squishy”. 

The March US jobs report (which came in at just 88K) was an example of disappointing weakness, accompanied by some weak U.S. housing and retail data. Building permits have declined since January. Single family starts were down 4.8%. Homebuilder confidence, which climbed to its highest level (47) since 2006 in December, stalled in January 2013 after an eight-month rise and fell to 42 in April. Foreclosure starts have also begun to pick up again.

Source: Citigroup

The IMF Lowers its (Too Optimistic) Global Growth Forecast 

The IMF lowered its 2013 global growth forecast, to 3.3% from 3.5% and its 2014 forecast to 4.0% from 4.1%, reflecting, 

a) Sharp fiscal spending cuts in the U.S. (sequestration, etc.) should shave about 0.3 percentage points from US GDP this year, 

b) Struggling, recession-striken Europe, with economic contractions in France, Spain and Italy expected this year. 

c) With the IMF was upbeat on China, mediocre growth here is sparking concerns that growth is slowing. 

d) The good news was that the IMF raised its forecast for Japan, ostensibly on the BoJ’s aggressive new monetary stimulus. 

To IMF cynics, these downward revisions haven't gone far enough, particularly as regards expected inflation. 

US Commerce Board Suggests US Economy Has “Lost Some Steam” 

The economy “has lost some steam” and will grow slowly in the near term, the Conference Board said Thursday as it reported that its leading economic index ticked down in March. The LEI declined 0.1% last month, following three months of gains, and economists polled by MarketWatch had expected the index to rise 0.2% in March. In February, the LEI rose 0.5%. The largest negative contribution came from consumers’ expectations. Other negative contributions came from building permits, a manufacturing new-orders index, weekly manufacturing hours and weekly jobless claims. 

Goldman Sachs’ Business Cycle Indicator Goes from Bad to Worse 

The latest Goldman GLI (global leading indicator) shows that the situation has gone from bad to worse. Consumer confidence, global PMIs, and industrial metals have all worsened significantly, pushing the Global Leading Indicator momentum down. Goldman's GLI also points to future deterioration in global industrial production. 

Hat Tip: Zero Hedge

The Spring Equities Swoon Revisited 

The disconnect was that while the economic data flow was increasingly falling below expectations, bond yields were falling not rising, the TIPs inflation premium was shrinking, and commodities were selling off, the S&P 500 was blithely ignoring this in hitting a new rebound high.

Over the past several years, investors have repeated a pattern of beginning the year with optimistic U.S. growth/recovery expectations, only for these expectations to evaporate by mid-year as waning data suggest sluggish activity, which has contributed to a “sell in April-May” and go away pattern in stock prices as investors fretted about a) a possible end to QE, b) sputtering economic growth and c) ongoing Eurozone crisis. 

Yet, in “selling in May and going away”, investors would have missed most of the next up-leg that took the S&P 500 to new recovery highs, with the entire move from the March 2009 low of 683.38 now representing a 132% gain over a period of just over four years. This time, the correction could be essentially the same, i.e., basically a reality check that does not seriously endanger the post great recession, QE fueled market recovery. While the apocalyptic bears are still out there, their hyperbole is somehow less believable than in 2011 or 2012.

Source: Yahoo.com, JapanInvestor

Short-Term Breakdown in S&P 500 

In addition to the yellow flags previously mentioned, cracks are forming in the S&P 500 rally itself. 

The S&P 500 index is recently unable to close back above its 50-day moving average. This is the first close below this key price level in 2013 as high-beta Tech (AAPL) and Homebuilders underperformed notably. Stocks are below Cyprus levels and marginally above Italian election levels. 

Hat Tip: Zero Hedge

The Trend is Still Your Friend 

The so-called momentum effect is one of the strongest and most pervasive phenomena of any market phenomenon studied. Researchers have verified its value with many different asset classes, as well as across groups of assets. The momentum effect works in terms of asset's performance relative to its peers in predicting future relative performance, and momentum also works well on an absolute, or time series basis, where an asset's own past return predicts its future performance. In absolute momentum, there is significant positive auto-covariance between an asset's return next month and its past one-year excess return. Absolute momentum appears to be just as robust and universally applicable as crosssectional momentum. It performs well in extreme market environments, across multiple asset classes (commodities, equity indices, bond markets, currency pairs), and back in time to the turn of the century.

In short, the trend is your friend until, like was seen in gold, it is decisively broken. 

Foreign Investors Pile Into Japan

Having ignited a virulent "short yen, long Nikkei trade", Shinzo Abe and his BoJ buddies continue playing the market psychology game to the hilt, knowing that a change in consumer, corporate and investor sentiment can be just as good as "real" change through what George Soros termed reflexivity.  Japanese policymakers know full well that public expectation of more deflation can become self-fulfilling, and they are actively trying to change the way ordinary Japanese think about prices, just as they have engineered a dramatic turnaround in foreign investor sentiment. 

They see the fight against deflation not just as one that involves measures like quantitative easing, but also psychic warfare: Once Japan’s consumers and business leaders believe prices will start rising, there’s a better chance people will go out and spend, putting pressure on prices to go up. 

Ryuzo Miyao, a member of the Bank of Japan’s policy board, has actually said that deflation will end in the current fiscal year (to March 2014). “The achievement of 1 percent inflation in fiscal 2014 has come into sight,” Miyao said. “The public’s inflation expectations will rise gradually, and in this situation the inflation rate is likely to rise above 1% during fiscal 2014.”

While Piling In, They Also Discuss Possible Loss of Control By the BoJ

For many years very underweight and generally very pessimistic about Japan, foreign investors have piled into Japanese equities since November of last year, and this buying accelerated to a record weekly figure last week, according to the Tokyo Stock Exchange. A new net buying record of JPY1.58 trillion was set in the second week of April, after the Bank of Japan unveiled new “shock and awe” quantitative and qualitative easing measures under newly installed Governor Haruhiko Kuroda. The new data put cumulative net purchasing by foreign investors since mid-November, when the decision to dissolve the lower house was made, at JPY8.15 trillion.

Source: Nikkei Astra, Tokyo Stock Exchange, Japan Investor
JPY Billion

At the same time, they continue to discuss the probability that the Bank of Japan (BoJ) would lose control of the printing press and how a rapidly declining yen could lead to a replay of the 1997 Asian currency debacle. Perma bear Albert Edwards points out that investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse. 

Japan Becomes Extremely Overbought

Regardless of whether the big Abenomics/BoJ bet eventually pans out, the following chart from Orcam Financial shows the Nikkei as the most overbought (i.e., above its 200-day MA) and Gold the most oversold, suggesting there is now ample room for a short-term mean reversion trade between the two (like short Nikkei, long gold), and this big contrarian call is exactly what CLSA strategist Chris Wood is now suggesting.

Hat Tip: Pragmatic Capitalism

The call is predicated on the non-belief that the US economy is "normalizing" and US QE will come to an end earlier than what investors currently expect. Indeed, it counts on the conjecture that the BoJ's bold move on QE is not the last by a long shot. For one, Mario Draghi at the the ECB would love to do more if he thought he could get it by Germany. Support for this view comes from three regional Fed bank presidents saying a further decline in US inflation below the Fed's 2% target may signal a need for more accomodation, not a potential curtailing of easing discussed by other Fed officials. 

Other brokers are beginning to suggest the Topix/Nikkei 225 is due for a 10% or so pause from the parabolic move upward since November of last year. In looking at individual stocks and sectors like Sumitomo Realty (8830.T) and the real estate sector as a whole, prices have already surged to Koizumi reform years peak levels, meaning a lot of the expected reflation for the foreseeable future is already priced in, given that Sumitomo Realty for example is already selling at a very rich P/E of 43X and a PBR of over 4X.

The Japan equity rally has been driven primarily by Nikkei 225 constituents, i.e., larger cap, more liquid names that foreign investors found the easiest to quickly raise their Japan exposure. However, the core 30, which includes more than its share of troubled electronic sector and other "dogs" continues to lag by a considerable margin. 

Source: Nikkei Astra, Japan Investor

The best year-to-date performers in the Nikkei 225 include many real estate companies, both first and second-tier, major retailers, second-tier financials, heavy industry stocks and even a couple of pharmaceutical companies.

Over the past month, however, buying has gone from "all in" to more specific sector and stock selection, amidst continued selling by domestic financial institutions who see this as an ideal time to unload unwanted strategic holdings. The biggest irony is that the electric power "zombies" are on the leader board. while the bank sector has taken a breather. The growing sector divergence is indicative of the emergence of quick sector rotation. 

Source: Tokyo Stock Exchange, Japan Investor

Crashing Gold, Falling Commodity Prices: End of the Commodity Supercycle Bubble?

The Gold Bubble Pops

When a financial market "bubble" first collapses, there is often no immediately compelling reason.     The real reasons/rationalizations for the collapse come afterwards. Gold's last bubble was in 1980 when it hit $800/ounce in nominal terms, and $2,187/ounce in 2009 US dollars. While the entire bull market lasted some 11 years, when gold moved over $700, it stayed there just a couple of weeks before plunging to the $300~$500 range. 

Source: True North, via Seeking Alpha

On Monday, gold futures for June delivery closed at $1,361 an ounce on the Comex in New York , a drop of more than $200 in two sessions, and the fall of 13% since April 11 was the biggest two-session decline since 1980. The dream of $3,000/ounce or even $2,000/ounce, so prevalent not so long ago, is over. In other words, the great bull market in gold is over. The GLD ETF briefly was the world’s biggest ETF, with assets north of $77 billion in August 2011, topping the SPDR S&P 500 ETF (SPY) for a time. Recently, the GLD ETF has suffered such intense differential selling pressure that its custodians have been forced to dump enormous quantities of physical gold. This is because GLD shares are dumped at a quicker pace than gold’s own selloff, creating an excess supply of GLD shares, forcing GLD administrators to  buy up this excess supply, and raising cash to do this by selling gold bullion. According to Zeal LLC, the recent “correction” in GLD’s holdings forced it to dump a staggering 169.8 tons (5.5 million ounces) of gold bullion simply to keep GLD shares’ price tracking gold! There are only two gold-mining companies in the entire world (Barrick and Newmont) that produce that much gold in a whole year. 

Source: 4-Traders.com; 

While Some Suspected Trouble Ahead for Gold, No One Knows How Far its Going Down Now

One of the first investment banks to officially turn bearish, SocGen declared the gold era was over and set an end 2013 target of USD1,375, near the time that Citigroup declared the end was nigh for global oil demand growth (on substitution natural gas for oil combined with increasing fuel economy). Goldman set a year end target of USD1,450 and said it could go lower, then nailed the selloff with  a "short gold" recommendation a week before gold really tanked. What did Goldman know that others didn't? 

Bloomberg Businessweek attributed the rapidly fading interest in gold to the realization that inflation was under control and falling despite "totally irresponsible" monetary policies that were rapidly eroding the value of fiat currencies. The JPMorgan Chase global consumer price index (covering more than 30 countries and 90% of global output) showed inflation peaking at 4% in 2011 and falling steadily since, while February 2013 prices were up only 2.5%. Bloomberg in another article blamed the selloff on, a) optimism that a U.S. recovery will curb the need for stimulus and b) the prospect that beleaguered members of the euro zone might be forced to sell gold to raise part of the funding, and there are much bigger holders in that category than Cyprus. Citigroup offered that the selloff was related to a break in technical levels and the general improvement in global risk appetitite. Business Insider argued that gold's collapse "vindicates the economic ideas of the economic (Keynesian, monetarist) elites. BigPicture blogger Barry Ritholtz opined that "Gold is the ultimate greater fool trade, with many of its owners part of a collective belief theory rife with cognitive errors and bias", that after a 14-year monster rally. 

But these explanations smack of rationalization, not an analysis of what really triggered the selloff. 

Has investor risk appetite and confidence in global economic growth and declining financial sector risk improved that dramatically in the last few weeks? Did investors wake up one morning and suddenly realize there was no global inflation? Only a short while ago, gold was touted as set to rebound with the BoJ's massive QE program and the inevitable response by other central banks. Europe remains in the intensive care unit, despite the protestations of its leadership and the indications of its nepotistic bond markets. Monetary operations have enhanced liquidity, but have done little-to-nothing to solve the real issue - which is insolvency. 

Gold bugs of course remain bullish on gold to the end, insisting the selloff was soley in the paper gold market while pointing out there is a shortage of physical gold, and insisting that investors shouldn't be concerned about the "temporary" pressure on gold. But since last Friday, someone has wanted to dump a large position of gold very badly. 

Someone who writes under the name George Washington on the Zero Hedge site quoted London bullion dealers observing that the gold futures market in New York on Friday last week saw a massive 3.4 million ounces (100 tons) worth of selling in the June futures contract, that was soon followed by 10 million more ounces (300 tons) of selling in the next 30 minutes of trading that looked suspiciously like short selling. Conspiracy theorists think the Fed was manipulating the gold market, claiming the 500 tons of naked shorts last Friday were instigated by the Fed. 

Brokers (Goldman, etc.) were reportedly warning their clients the word was out that hedge funds and institutions were going to be dumping gold. Others blamed the Japanese. 

End of the Commodity Supercycle?

In fact, no one knows for sure, and that is what is disturbing. Rapidly rising bullion prices were ostensibly a manisfestation of loss of confidence in the dollar as well as other fiat (paper) currencies, and a reflection of expectations for even more fiat currency depreciation, as well as fears that the Eurozone would simply fall apart. As the BoJ uncorked its massive QE, gold was supposed to take off again. But the ECB's balance sheet is now actually shrinking, and the Fed is talking about possible exit strategies--possibly leaving the BoJ as the last to the party. Gold actually may be reading the dotted line in the chart below going down, not up. 

Hat Tip: Zero Hedge

Its not only gold, but the whole commodity complex. The CRB commodity index peaked in 2007 on booming global trade after a 2-year, 65% blowoff, then crashed when the global financial crisis hit. Commodity prices then rapidly re-inflated on massive QE, liquidity provision from central banks to a secondary peak in 2011, ostensibly on the assumption that all of this money printing would inevitably unleash inflation, but is now some 40% below the 2007 high. 

Source: 4-Brokers

"Dr." Copper Rally Fizzles

The Wall Street Journal is reporting that two major commodities-trading firms have amassed much of the world’s copper supplies in their warehouses, partly by paying to divert shipments away from other storage hubs, traders and analysts say. Copper prices are near 8-month lows and more losses are expected. Until the latest selloff, prices were down around 6% YTD as inventories have steadily climbed while demand in China has been disappointing. The Thomson Reuters GFMS sees copper dropping to as low as US$6,500/t in 2013 as high warehouse inventories and weak demand from Europe and China pin down prices. So much for copper calling a major recovery in the global economy. 

Source: 4-Brokers

Crude Oil Too

As previously mentioned, Citigroup has already declared the end was nigh for global oil demand growth on the substitution of natural gas for oil combined with increasing fuel economy.  Like the GLD ETF, selloffs in the copper and oil commodity investor ETFs will force further selling of the underlying commodity. 

Source: 4-Traders

What Does Commodity Selloff Tell Us About the Real Economy and/or Stock Prices?

The experience of most investors today (with the exception of  Japanese investors for the past 20 years) is within an environment of inflation and growth, and they naturally believe that long-term bond yields have a positive correlation with commodity prices because of what commodity prices are signalling about future inflation. They have also been conditioned to believe that bond yields and stock prices are positively correlated. 

Neither however has been true since before the financial crisis. 

1) Commodity Prices and Long Term Bond Yields

From 1980 until the spring of 2002, 10-year Treasury bond yields had a positive correlation with the CRB index. Since 2002, however, there has been a dramatic divergence between Treasury yields and commodity prices. The general assumption heretofore is a) that the 1980~2002 bonds/commodities relationship is valid, and b) the divergence is unsustainable. The assumption was that bond yields must eventually rise to meet the "real trend" in commodity prices, as commodity prices are a leading indicator of inflation, and bond yields discount both expected growth and expected inflation. 

But the recent selloff in commodities is strongly suggesting this assumption is wrong, and that any notion that the massive QE being practiced by the developed country central banks is inflationary is equally wrong-headed. As Cullen Roche of Orcam Financial (and other modern fiat monetary system theorists) has consistently maintained, QE is essentially just an asset swap that changes the composition of private sector financial assets, and doesn't increase net financial assets in the private sector. While QE has had some impact on artificially lowering rates and a significantly positive psychological impact on stock prices, QE in and of itself does not cause inflation. If this is true, commodity prices are now marking to bond yields, not the other way around.

Source: Yahoo.com

2) Bond Yields and Stock Prices

How about the relationship between stock prices and bond yields? Until around 1985, long-term bond yields in the U.S. were positively correlated with stock prices. After 1985, however, stock prices have become negatively correlated with bond yields. As the SP 500 renews its pre-crisis highs, long-bond yields continue to decline, meaning bond prices and stock prices are both rising as inflationary expectations wane. 

Source: Yahoo.com

Since bond yields discount both expected inflation and GDP growth, the current US 10-year bond yield of 1.71% would seem to be essentially discounting, a) no inflation and under 2% GDP growth, or b) minimal inflation and GDP growth of just +/-1%, while the US stock market appears to be discounting much higher GDP or at least corporate profit growth. If 2%+ US economic growth is actually a myth and does ever collapse, look out below for stock prices, as investors wring out unrealistic growth expectations from stock prices in a manner similar to what has happened in Japan over the past decades. 

Gold Selloff Bearish for Nikkei 225, Bullish for JPY

Japan's Nikkei 225 has historically displayed a positive correlation with gold prices and an even tighter positive correlation with US 10-year bond yields. Here again, we are seeing a growing divergence because of "artificial" policy initiatives, as Abenomics has dramatically depreciated JPY while US bond yields remain subdued. 

Source: Yahoo.com

The Nikkei 225 has recently been moving in lock-step with JPY/USD, even though the focus of the actual Japanese stock buying has been on domestic reflation plays, not the exporters. The rout in gold has quickly pushed JPY/USD three yen stronger than the recent low of just under JPY100/USD, which had paused on a warning from the US Treasury department that Japan abstain from "competitive devaluation" of JPY. 

Source: Yahoo.com

As long as the Japanese government and BoJ are aggressively working to reflate Japan and weaken JPY, the slippage in the traditional JPY/USD driver, i.e., the spread between 2-year Japan and US bond yields and JPY/USD, is likely to persist. Whether the BoJ's actions can weaken JPY back to 2007 levels (around JPY124/USD) however remains to be seen given increasing concern about a competitive devaluation of JPY. 

While economic historians are still arguing about just what part of Koreikyo Takahashi's policy mix (i.e., fiscal expenditures, BoJ purchases of JGBs and currency weakening) in what Ben Bernanke praised as brilliant, we posit that what worked the most in both Takahashi's and FDR's efforts to reflate Japan's and the US economy in the 1930s was a substantial depreciation (40%) of the currency, which in both cases amidst the gold standard economic "religion" at the time considered unmitigated blasphemy. 

Domestic Bond Investors are Confused: Does the BoJ Really Want to Keep Rates Low or Boost Inflation to 2%? They are Having Trouble Getting Their Head Around Both

Japanese bond investors are also very confused about what Kuroda's 2% inflation commitment really means for JGB yields. "Essentially we now have a national policy that says investors should buy risk assets by borrowing cheaply. So if you think interest rates will be higher two years from now, you would have some hesitation in buying anything longer than five years," said Hidenori Suezawa, chief fixed income strategist at SMBC Nikko Securities as quoted through Reuters. Japanese bond investors"simply cannot grasp what the BOJ is getting at," said Katsutoshi Inadome, fixed income analyst at Mitsubishi UFJ Morgan Stanley Securities, also via Reuters. Assuming Japan can achieve 2% inflation and stimulate Japan's economy to achieve 2% growth, JGB yields should ostensibly rise to around 4% if investors really believed the BoJ can pull it off. Since this would essentially blow up Japan's public finances, the BoJ has committed to buying essentially 1.5% of Japan's GDP in JGBs indefinitely to prevent JGB yields from discounting this possibility. 

What's the BOJ's priority? Keeping rates low or boosting inflation to 2%? If it is the latter, buying five-year bonds yielding 0.2% would be a disaster for domestic investors. This uncertainty and lack of confidence is what is causing a sharp surge in government bond market volatility.

Tokyo Quickly Regains Composure After US Selloff

Despite waking up to bad news of a significant US selloff and a sharp reversal in JPY/USD overnight, the Tokyo market quickly regained its composure, with the Nikkei slipping only 0.4% and JPY/USD re-weakening. With Abenomics now in full force, Japanese stocks are much less susceptible to overseas market volatility. Any short-term correction (and not a collapse) in US stock prices will be viewed as a chance to add some more exposure to Japanese equities.

Our concern however is that the domestic reflation plays have already surged in parabolic fashion to the Koizumi reform highs, whereas we do not see the Nikkei 225 as being able to seriously breach the prior 18,000+ plus Koizumi high (in 2007) without evidence that a restructuring/re-invention wave is underway in Japan's economy, as we see restructuring/re-invention as the real driver of sustainable growth in Japan going forward. In other words, the first two "arrows" of Abenomics, i.e., bold monetary policy and more active fiscal policy, as basically buying time for structural reforms to adjust Japan's economy to a new world order.