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Current edition contains:

 

IS THE STRENGTH OF JAPANESE YEN TO CONTINUE INTO 2010?

1

We expect the carry trade status to be swapped from USD back to JPY.

 

IS GOLD A BUBBLE?

2

Analysis of supply and demand for gold.

 

WE STILL PREFER SWEDISH KRONE OVER THE COURSE OF 2010

3

Reasoning for our favorite trade.

4

RAW MATERIALS ARE PREDICTING STRONG ECONOMIC RECOVERY TO CONTINUE Alternative indicator for assessing the economy.

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1)

IS THE STRENGTH OF JAPANESE YEN TO CONTINUE INTO 2010?

By the end of 2009 we witnessed climax of Japanese yen strength against US dollar as it touched peak levels of 85 USD/JPY. There is a series of reasons for such behavior, ranging from a) pulling investments from abroad by domestic aging population who is going to finally spend its savings, b) repatriation of funds due to time-limited tax breaks, c) higher real yields on both short and long government bonds, as well as d) unwillingness of Japanese central bank to start printing presses in earnest and pull the economy out of rooted deflation.

Taking the long-term perspective, it is hard to say the Japanese yen is too under or overvalued, in comparison to excessive valuations from mid 1990s, yen is now trading in a reasonable band. Based on PPP, yen seems to be overvalued by less than 5%.

USD/JPY - PPP (CPI)

160 USD/JPY (LHS) Cheap yen (RHS) Expensive yen (RHS) 100 110 120 130 140 150 70%
160
USD/JPY (LHS)
Cheap yen (RHS)
Expensive yen (RHS)
100
110
120
130
140
150
70%
170
80
90
-30%
-10%
10%
30%
50%

Yet the main reason for yen’s appreciation is the liquidation of carry trades as the US dollar was featured into the

leading role of this plot since March. This was happening on the back of lower real and nominal interest rates. As you

can see on the chart below, the spread between 3 month LIBOR rates dropped in favor of Japanese’s yen to a

medium-term low.

3M LIBOR Spread USD-JPY

%

5,75 4,75 3,75 2,75 1,75 0,75 -0,25 95 85 145 135 125 115 105 US -
5,75
4,75
3,75
2,75
1,75
0,75
-0,25
95
85
145
135
125
115
105
US - JP 3M LIBOR Spread (LHS)
USD/JPY (RHS)

In case the recovery in United States proves to be strong enough for Fed to start interest rates by second half of next year, USD/JPY pair could start moving back to a 110 level, which we believe would suit Japanese economy much better, given the horrific fiscal and demographic fundamentals. Unless the government stops being detrimental to Japanese economy as it has been the case for long time, only a strong export sector may lead the way out for Japan, thus a weak yen may be well need soon.

2)

IS GOLD A BUBBLE?

No matter whether gold lovers look at their gold position from left or right, the futures seems to always look bright. And it looks like gold is the best diversification tool according to their arguments, too. In our eyes, gold is just another bubble in the forming.

The arguments of gold investors stand clear: „Gold protects against hyperinflation that is to come as a result of

excessive money printing across the world. In reverse, a deflationary spiral would extinguish the credibility of those in charge of price stability, leading the world to seek a sensible anchor like gold. Ownership of gold is perfectly

uncorrelated asset with the return profile being positively skewed.“ Before we investigate these arguments, let us

have a look at fundamentals influencing the price of gold.

SUPPLY AND DEMAND

Almost two thirds of demand is related to the jewelry, mostly within emerging world. Industrial usage is quite stable around 12%, being quite negligible. Over long term, speculative positions formed 15-20% of demand, increasing to 40% of overall demand this year. Therefore speculation is the main drive of current appreciation, yet over long term, you need to follow price of dollar and level of income in emerging countries, as it explains gold price from more than 80%. This relationship justifies price of gold at about 820 USD / ounce, i.e. about 35% below current price. This marks a largest deviation from fair price since 1980, thus our belief of a bubble.

Mining represents 60% of current supply. Other sources are recyclation of gold and sales by IMF and central banks. In fractional banking system, for central banks, keeping gold is connected especially with storage costs.

HEDGING AGAINST INFLATION? WHAT INFLATION?

The reasoning of rise in inflation is derived from central banks actions and increase in monetary base. For all, let us mention Federal Reserve doubling the monetary base in less than a year, monetizing long term government debt and still not being finished with purchases of mortgage backed securities. Here gold should play a role of inflation

hedge and fall in US dollar. There are, however, at least three reasons why inflationary destiny is not

carved in stone at all.

  • 1. Friedman’s paradigm that inflation is always a monetary phenomenon was proved invalid in case of Japan. During 90s, Japan increased monetary base by more than two and half fold, yet even after twenty years, it has not won the battle with rooted deflationary pressures.

  • 2. Deflationary risks in US are still noteworthy. Elevated unemployment, low utilization of production capacities, low propensity to bank lending, and the possibility of immature withdrawal of governmental stimulus may lead to deflationary spiral. In the world of tremendous debt levels, wars with deflation may hardly be won overnight.

  • 3. Buying gold today does not provide sufficient inflation protection as the prices are already elevated. Whoever was buying gold at the beginning of 1980s is still waiting for the inflation adjusted return on invested capital. We argue that inflation would have to be galloping for any meaningful returns on gold and that investment into global equities provides better inflationary protection for a mild inflationary forces.

Today the long speculative positions as a ratio of open interest as read from CFTC report stands at historical highs. Call options are much more expensive than put options despite even probability of price movements. And given structural problems of European sovereigns, yet another dollar weakness play, we believe buying gold put options as a cheap portfolio hedge against deflation.

3)

WE STILL PREFER SWEDISH KRONE OVER THE COURSE OF 2010

With a focus on IT, machine tools, telecommunication, and high-end consumer goods, Sweden has historically been a cyclical market. And with the global cycle now expanding, Sweden should do well. Yet looking over past three months, Swedish krona has been the worst underperformer against Euro among the major currencies. So is there an interest trading opportunity for a short EUR/SEK trade shaping up or are we just missing something? Let us do a quick review of Swedish currency drivers:

  • 1. Exposition to the Baltics

The Swedish financial system is obviously in peril due to a very large exposure to the Baltic nations. This exposure, which stands at approximately USD 76bn, is equivalent to 15% of Swedish nominal GDP. And while Baltic NPLs are now hovering around 5%, they rose to as much as 25% in the last systemic shock of the 1990s. With that in mind, it is not hard to understand why investors would be wary of the Krona. Yet one has to wonder how much of the Baltic risk has already been priced in?

While we recognize risks that weigh on the Krona, some of the recent weakness may be overdone, especially against the Euro (which carries a similar risk of imploding some of its peripheral states). Given the recent flattish trading in credit default swaps on Latvia and Lithuania, as well as in Swedish financial stocks, we do not perceive Baltic risk as increasing.

  • 2. Well run public policies

Contrary to what we are seeing in US or Eurozone, the Swedish government has refused to bail out any industrials, including Volvo or Saab. The fiscal indebtedness stands out as one of the best in Europe, boasting roughly 40%, well under the Maastricht criteria.

Sweden is one of the few European countries with a fully-funded pension scheme. Given the aging population across Europe, this theme will be emerging with more and more vengeance.

  • 3. Trade and current account position

Despite a major drop in exports, Sweden is still able to generate current account surplus at well above 7%. This statistics can be envied by almost any country in the world and shows a clear currency appreciation pressures. With two biggest trading partners (Germany and Norway) resurging from recession, the Swedish exports should increase with a modest lag.

  • 4. Domestic economy

Export and industrial sector are still struggling to lead the economy from the recession; the other parts of economy have, however, taken the burden of heavy lifting on its shoulders. This is all the more true since the Riksbank’s ultra- low rates are really pushing investors to take risks.

  • 5. Rates may be increased sooner than in autumn next year

Central bank expressed its stance to keep the rates ultra low until autumn next year to help fight deflationary pressures and high unemployment. Yet with labor force data, retail sales, and household lending way stronger than expected, the Risksbank may eventually re-evaluate the course of actions and start rising rates sooner.

4)

RAW MATERIALS ARE PREDICTING STRONG ECONOMIC RECOVERY TO CONTINUE

Today we will introduce you another indicator we like looking at. It is called The Journal of Commerce Smoothed Price Index and is complied weekly by Journal of Commerce in conjunction with Economic Cycle Research Institute.

The reason why we really like this indicator stems from its composition. The index tracks the annual growth of 18 industrial commodities, half of which are not traded on US exchanges and thus are less likely to be a skewed by hedge funds manipulation or speculative buying. It does not include agricultural commodities or precious metals such as gold or silver, but only materials that are used in industrial production, such as nickel, tin, aluminum, plywood, ethylene, benzene, cotton, burlap and crude oil.

This index may be looked upon as a fine measure of confidence, in other words, how manufacturers will back up that confidence by paying for their raw materials.

Raw-material prices signaling economy direction

index

-2 US, GDP Q/Q annualized (RHS) Journal of Commerce Industrial Price Commodity Price Index (LHS) 03
-2
US, GDP Q/Q annualized (RHS)
Journal of Commerce Industrial Price Commodity Price Index (LHS)
03
05
02
01
09
07
08
06
04
-8
-6
-4
80,00
0
8
6
2
4
-80,00
-60,00
-40,00
-20,00
0,00
20,00
40,00
60,00

The index’s rally predated U.S. economic expansion in the third quarter and signals average annual growth of 3

percent plus in the next two quarters as manufacturing increases. It also captured well the global recovery already in

late November 2008 as China started purchasing commodities with gusto. This commodity index may be actually one of the best leading indicators of global industrial growth.