As financial markets face escalating macro, liquidity and geopolitical risks, in addition to uncertainty with U.S. presidential elections, the search for that ultimate safe haven grows in importance.
The threat of the UK exiting the biggest common economic union, the possibility that presumptive GOP nominee Donald Trump would adopt highly protectionist policies toward U.S. trading partners and restructures U.S. debt, the continued plunge in sovereign and corporate European and Japanese bond yields below zero are all considered sources of the uncertainty in the markets.
From the start of the year to mid-June, gold and the yen were the best performing assets in U.S. dollar terms (see “Store of value”). Among the usual safe havens, namely the yen, gold, Swiss franc and bonds, the yellow metal has outperformed consistently since mid-January.
So, which of the two will prevail in the second half of 2016?
Contrary to many who had expected further quantitative easing from the Bank of Japan in 2015, we stuck with our long-held position that the Bank of Japan would stand pat throughout 2015 and 2016. By mid-June, the yen had been the best performing G10 currency. Since then, Japanese corporate profits have improved, the GDP was revised out of recession and the BoJ has grown less pessimistic with the economy -- all reasons to not add to quantitative easing, even if that means the BoJ’s 2.0% inflation target will take time to materialize.
Moreover, supply and demand continue to dictate the BoJ’s immobility. After rocking global markets with its 2014 decision to raise QE by ¥15-20 trillion per month, the BoJ may have finally reached its limit.
At the current pace of asset purchases (which include Japanese Government Bonds and even equity ETFs), by end of 2017, its holdings of JGBs would have risen from ¥200 trillion to ¥500 trillion.
The BoJ will have to buy ¥40 trillion from existing holders to hit its current annual target of ¥80 trillion in bond buying. Finding sellers/owners of JGBs among insurance companies and pensions funds is highly unlikely as these will simply not sell. Insurers need JGBs for asset-liability balancing, while pension funds such as the Japanese Pension Investment Fund (world’s biggest) have disposed of enough JGBs as part of their bonds-to-equities rebalancing.
One potential alternative for the BoJ to expand its easing policy is via exchange-traded funds. Out of the ¥80 trillion a year, the BoJ allocates ¥3.3 trillion for ETFs. Needing fresh assets to meet its ¥32 billion monthly ETF buying spree, the BoJ has asked index and ETF companies to design new ETFs to welcome its demanding purchases. Chatter since last December that the BoJ would spend an additional ¥300 billion per year into a range of new equity produces has yet to materialize. But if it ever does, the yen could sustain a short-lived blow.
After a difficult 3-and-a-half years of receding inflation and a broadening U.S. bull market, gold finally raged back. As most global central banks became increasingly stuck at negative interest rates, and the Fed unwilling to follow up with its December rate hike, gold’s substitute characteristic took over. The main watershed event likely to boost gold significantly higher could be the near-inevitable U-turn from the Fed back to negative interest rates. While this may sound a little exaggerated, as recent as May, Fed Chair Janet Yellen said the Fed could always shift back to negative interest rates if the economy stalls anew.
Note that even after last year’s rate hike, the Fed emphasized its accommodative policy stance by maintaining its $4.5 trillion balance sheet intact (not selling any of the bonds it purchased in QE1, QE2, Operation Twist and QE3), thereby enabling it to raise rates further (if the economy warrants it) and bolster its buffer in the event it needed to cut rates later, which is more technically and politically feasible than launching new round of QE.
The conditions warranting future rate hikes require further improvement in price and wage dynamics and the status quo (at minimum) in the labor market. But today, the job market appears to have reached full employment, which also means it’s nearing a peak as seen in the last three nonfarm payroll figures.
Yet, before the Fed moves into negative rates, we would have to witness a combination of intensifying deterioration on the macro front (services, jobs and higher spreads and bankruptcies), rather than only surging market volatility.
Surging leverage in emerging markets and the rise in non-performing loans has not been shadowed by China and oil stories. These could well provoke a break in liquidity, prompting central banks to expand stimulus to the benefit of gold.
The yen could well drag the U.S. dollar to 100, but it is gold that faces further upside. Simply, for the Fed to keep rates on hold and the rest of the world at or near negative rates is sufficient to prompt gold to $1,500 per ounce by Q1 2016.