Monday, February 4, 2013

Yen and Yield

Two trends have been occurring in the last three months that have not gotten a lot of attention by the popular press but you need to be aware of to protect your investment portfolio.

First, the yield on 30-Year Treasury Bonds has increased from 2.72% shortly after the November election to 3.21% on Friday.

Second, the Japanese yen has lost substantial value against the US Dollar over the same period.  In November, a dollar would get you 79 yen.  As of Friday, it provides you with almost 93 yen-that is a 18% decrease in the value of the yen in just three months.  The loss compared to the Euro has been even larger-about 20%.

Let's consider the practical implications of this currency movement as viewed by Bruce Krasting.  Krasting points out that three months ago if you were comparing a Lexus LS 460 and an Audi A8 they both would have set you back about 80k.

Three months ago... the relative value of these cars was equal. If you assume that 80% of the cost of the car was the imported value, then you were “paying” 50,394 Euros for the Audi and 5,120,000 Yen for the Lexus. At the exchange rates in early November, the Euro component of the Audi was $64,000 (80,000 X 80% X EURUSD 1.27). The Yen cost was also $64,000 (80,000 X 80% /80.00). The EURJPY exchange rate was 102. 
Today the EURJPY FX rate is 1.2650. The dollar cost of those Euros and Yen have changed substantially. $68,900 is now the Euro component of the Audi (+3,900). The dollar cost of the imported Lexus has fallen to $55,350 (-$8,649). Looking at just the FX rate changes, the cost of the Lexus is down to $71,350, the Audi is up to $84,910. In three months there is a $13,560 price gap. Now which one do you choose?
I bring this up to make the point about how very rapidly the terms of trade have turned against Germany (all of the EU) and in favor of Japan.
Of course, the sticker price on the Lexus will not change immediately, but you can see where this is going.  And it is not good for the Europeans who are already struggling to get their economy going.

However, Krasting also sees potential trouble in the equity markets as a result of this foreign exchange volatility.

What we are witnessing is Yen weakness (yes, coupled with Euro strength vs the $). The rate of change has been very substantial, arguably, this is the most volatile period in FX over the past 15 years.
Compare the prior periods of FX upheaval to today. In many ways, what has happened of late with the Yen versus the major currencies is unique to history. What is also amazing (to me) is that this FX violence is happening at a time when equity markets are soaring.
From 1999 – 2003 NASDAQ fell 70%, the S&P got clipped for 40%. 2008 – 2009 was a horror show. Today, the equity markets are thriving on the FX instability.
Are we in one of those “New Paradigm” things with markets again? A financial world that can go through a very turbulent period in FX, while there is no fallout anywhere else?

Let's return to the increasing yield on the long bond.

3.21% is still an incredibly miniscule yield for loaning anybody money for 30 years.  Consider the fact that the average 30-year yield since the Treasury started issuing these bonds in 1977 has been 7.25%.

Increasing interest rates have historically not been favorable for equity returns. This is due to the fact that the bond market is much, much bigger than equity markets.  It is usually at least four times the size of the equity markets globally. Therefore, as the yield on bonds goes up, it results in bonds attracting capital away from stocks.  Conversely, as interest rates fall, equities become relatively more attractive to investors.

The charts below give you a perspective on the relative sizes of the equity and bond markets and how they have grown over time.  Due to the size difference it does not take a lot of movement in or out of the bond markets to have a significant impact on flows in and out of the equity markets.

Source: QVM Group, Inc as of August, 2011

Considering all of the above raises questions in my mind about the sustainability of the S&P 500 rally that has seen stock prices rise 12% over the last three months.  Looking at history, you would not expect to see equity prices increasing in a time of foreign currency volatility and rising interest rates.

Has the world changed such that trends like this don't matter any more?  We are in uncharted waters but I would be surprised if the financial currents are not just as strong as they have ever been in situations like this.  My advice is to keep your hands firmly on the wheel guiding your wealth.  As always, be more focused on the return of your capital than the return on your capital.

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