After $150 Billion Buying Binge, "Tokyo Whale" Seen Paring Back ETF Purchases In 2018

A few months ago, we noted that the Bank of Japan had decided to throw every textbook out of the window and crank their plunge-protection to "11"after reports surfaced that they owned a staggering 75% of Japan"s ETFs.

The BOJ first started their buying spree in December 2010 - when they held no ETFs at all - and have since accumulated some $150 billion in aggregate holdings.  The buying was all as part of unprecedented "economic stimulus" which has undoubtedly contributed to the Nikkei 225 Stock Average surging roughly 125% since December 2010.

Here"s a quick graphical recap of the program courtesy of Bloomberg...

...and another look which shows the central bank owns three quarters of ETFs by market value...

 

...all of which has resulted in the following bubble stock market appreciation...

Not surprisingly, since the program started, everyone from the head of the country’s stock exchange to the chairman of the Japanese Bankers Association has questioned the ETF program’s size and whether it artificially depresses volatility.

Now, with the Nikkei surging to 25 year highs, analysts are increasingly saying it"s time for the BOJ to put this specific component of their many controversial bubble-blowing policies to rest.  Per Bloomberg:

Sometime next year, the BOJ will cut its annual buying target for domestic exchange-traded funds by as much as a third from the current 6 trillion yen ($53 billion), says Toru Ibayashi, head of Japanese equities at UBS Wealth Management in Tokyo. Soichiro Monji of Daiwa SB Investments Ltd. expects a similar reduction, but by the end of March.

 

“Four trillion yen,” UBS’s Ibayashi predicted. “And everybody will understand.”

 

"Fear of deflation was behind the 6 trillion yen target,” Daiwa SB’s Monji said in an interview. “We’re no longer in that kind of environment. Risks are now skewed toward the upside, rather than the downside. It’s hard for the central bank to justify its buying spree.”

 

“Given the circumstances at this point in time, it is difficult for the BOJ to keep buying ETFs at six trillion yen per year,” Ibayashi said.

Jonathan Garner, chief Asia and emerging markets equity strategist at Morgan Stanley in Hong Kong, described the ETF purchases as “perhaps the most controversial part” of the bank’s stimulus program which includes everything from negative interest rates and yield-curve control to buying tens of trillions of yen of bonds each year, on top of its stock purchases. 

Of course, not everyone agrees as Naoki Kamiyama, chief strategist for Nikko Asset Management Co. in Tokyo, and Hisao Matsuura, a strategist at Nomura Holdings Inc., both saying the BOJ won’t cut its ETF target anytime soon as "it would hurt investor confidence and make a pickup in inflation much less likely..."

You know, because every central bank"s primary objective is to boost "investor confidence" by creating massive asset bubbles that make the masses feel richer...at least until the marginal stimulus fails and the whole ponzi comes crashing down...

Foreigners Bought A Record Amount Of Japanese Stocks, Just Before The Nikkei Snapped

There was something poetically ironic about last night"s 800+ point crash in the Nikkei...

... which was saved in the last minutes of trading by what was rumored to be the latest blatant BOJ intervention: it took place right after the month in which a record number of foreigners rushed into Japanese stocks, chasing the record momentum of the Nikkei and Topix.

 

According to the latest data from the Japanese MOF, in October foreigners made the largest investments ever in Japanese equities in October.

First, what did Japanese investors do? Having as recently as several months ago bought up record amounts of US Treasurys, this enthusiasm has long since vanished, and local investors were net sellers of foreign long-term bonds (-¥1.43 tn) for the second straight month. However, in each month of 2017 so far, Japanese investors have remained net buyers of foreign bonds (excluding banks whose monthly transactions are volatile and also dollar funded), although the pace slowed slightly at +¥727.7 bn, according to Goldman calculations. Trust banks" investment trust accounts (including pension funds), financial services providers, and life insurers were net buyers, at a stable +¥267.5 bn, +¥659.0 bn, and +¥420.4 bn respectively.

Japanese investors were also busy buying foreign stocks: they bought a net ¥1.0 tn of foreign equities in October, and have sustained their amount of net purchases at above ¥1 tn since May.

However, what is more notable is what foreigners were doing with Japanese assets this time, and as noted above, foreign investors were net buyers of Japanese equities in October (+¥3.43 tn), after being net sellers in Aug-Sep (-¥2.65 tn). This represented the largest investment in Japanese equities in a single month since the beginning of comparable statistics in 2005. It also explains the Nikkei"s unprecedented surge last month, in which the Japanese index had just one day in all of October.

Inward - outward security investments

Source: Goldman Sachs

Looking at net overall capital flows through portfolio investment in October, funds flowed in via inward security investment by ¥1.53 tn (with foreign investors net buyers of Japanese securities) and via outward security investment by ¥334.4 bn (with Japanese investors net sellers of foreign portfolios), making for an overall inflow of ¥1.86 tn (September: outflow of ¥2.43 tn).

Source: Goldman Sachs

The trick, for Abe whose investor-friendly election last month was the main catalyst for the influx of foreign money, is that just as foreign money comes easily chasing upward momentum, it can and will leave just as easily, and once said momentum is lost - and if there are any more surprises like last night"s mini crash - watch as all the transitory Nikkei gains from the past month are exposed to be just that.

One Year Later: These Are The Best And Worst Performing Assets Under President Trump

"A Happy Trumpiversary to all our readers this morning"

       - Deutsche Bank

Today marks exactly 12 months since the US election on November 8th 2016, and as Deutsche Bank writes in "A Happy 12 Month Trumpiversary For Markets?" a lot has happened in the last year, although most surprising may be that for all calls of market collapse should Trump get elected, the S&P 500 has actually soared over 20% in the past 365 days according to Goldman which recently calculated that the Trump rally so far ranks as the fourth-best 12-month gain following a presidential election since 1936, trailing only Bill Clinton (1996, 32%), John F. Kennedy (1960, 29%), and George H.W. Bush (1988, 23%). 

As Deutsche Bank then picks up, "needless to say that the victory was unprecedented and also a massive shock around the world. Following Trump’s victory, it was widely expected that we’d see a much higher chance of fiscal spending but also a reinforcement of the backlash against globalisation and associated forces of which migration policy and trade were probably first and foremost. In reality what we have seen in the last twelve months is plenty of evidence of backlash against globalisation, hostility and controversy, but very little in the way of fiscal policy."

Here is the rest of Jim Reid"s observations on how the market has progressed so far under president Trump.

The debacle around healthcare reform probably best characterises the difficulties the President has faced in that regard. So with today marking the one year anniversary, we thought we would take a look at how markets have performed over that time period. For the purpose of this we’ve included our usual monthly performance assets, as well as a few other US assets. First and foremost after running the numbers what stands out is the sheer number of assets which have seen positive returns. Indeed in USD terms, out of a sample of 41 assets, 38 have seen positive total returns.

 

As we know US equity market performance has been relentless. The S&P 500 has returned +23.5% over the last 12 months and has seen a positive total return in every month since Trump was elected. Interestingly this hasn’t actually been the best 12 month performance for the S&P 500 following an election. That award goes to the 1944 election victory for Franklin D. Roosevelt which saw the S&P 500 rally +36.8% in the year following. The twelve month performance post Trump ranks 7th in the last 23 elections. Meanwhile the Dow has rallied +31.5% and the smaller-cap Russell 2000 index has returned +25.4%. It hasn’t just been US equity markets that have seen blockbuster returns though. Indeed it’s very much been a global rally. The biggest winner is the FTSE MIB (+47.8%) while also in Europe the DAX has returned +34.1%, Stoxx 600 +27.9%, Greek Athex +38.2% and IBEX +24.9%. The UK’s FTSE 100 has returned +21.4% while in Asia the Nikkei is +25.5% and Hang Seng +30.7%.

 

In bond markets, as we know Treasuries have seen some huge ranges but ultimately performance has been benign. Indeed Treasuries have returned -0.1%. In fairness the big move for Treasuries came in the first few weeks of the election victory where we saw 10y yields spike nearly 80bps. If we take performance from the yield highs of last December then performance is actually more like +3.5%.  

 

More significant for bonds though has been the shape of the yield curve. Having spiked as high as 136bps, the 2s10s curve has now flattened to just 68bps and is at the flattest since 2007. The 5s30s curve (79bps) is also at the flattest in 10 years. Alternatively 2y yields have moved from 0.854% on election day to 1.629% now and the highest in the last year. 10y yields were at 1.855% on election day, touched as high as 2.626% in March and are now at 2.309%. The equivalent for 30y yields is 2.616% on election day, 3.212% high in March and 2.770% now.

 

So while equity markets may have benefited from high expectations for fiscal spending, US Treasuries have by and large priced out any expectation with each passing day under Trump’s presidency.

 

In terms of other markets, credit markets have returned anywhere from +2.9% to +14.4% with higher beta credit outperforming (HY and Sub-Financials). Emerging markets have also had been swept up in the rally with EM bonds returning +4.7% and EM equities +28.6%. Commodities have been more of a mixed bag. Gold is unchanged over the time horizon while Silver has dropped -7.8%. On the other hand Oil is up +26.6% and Copper +29.7%.

Sprint, T-Mobile Plunge: SoftBank Calling Off Merger

Sprint stock plunged, and was halted by the exchange volatility trigger, when the Nikkei reported moments ago that Japan"s SoftBank Group plans to break off negotiations on the long-awaited merger between its subsidiary Sprint and T-Mobile US due to a failure to agree on ownership of the combined entity, "dashing the Japanese technology giant"s hopes of reshaping the American wireless business."

According to The Nikkei, SoftBank is now expected to approach T-Mobile owner Deutsche Telekom as early as Tuesday to propose ending the negotiations. The pair had reached a broad agreement to integrate T-Mobile and Sprint - the third- and fourth-largest carriers in the U.S. - and were ironing out such details as the ownership ratio.

The German parent had insisted on a controlling stake, according to a source familiar with the situation. Some at SoftBank were initially amenable as long as the Japanese company retained some influence. But SoftBank"s board affirmed at a meeting Friday that the company would not give up control. The decision was made Monday to call the talks off.

Meanwhile, in the latest nightmare announcement for M&A arbs, Sprint tumbled as much as 13% before resuming, with TMobile also dumping, as it now appears that this endless merger process is finally dead.

The "Iron Coffin Lid": Why The Euphoric Surge In Japanese Stocks Is Coming To An End

Last week, Japan"s Nikkei 225 index enjoyed its longest winning streak in history which eventually ending after 16 consecutive days of gains, only to resume rising after a brief one day hiatus. And, as foreign investors once again flood the Japanese stock market, chasing the momentum which has pushed local stocks to levels not seen since 1996, the question on everyone"s lips is how much longer can this continue?

Offering a decidedly downbeat outlook on Japan"s market exuberance, Shannon McConaghy - portfolio manager at what we have in the past dubbed the world"s most bearish hedge fund, Horseman Capital Management - believes that the euphoria is about to end. The reason: the ominously sounding "Iron Coffin Lid."

In a note released late last week, McConaghy writes that there has been a lot of excitement over Japanese equities of late, with hyperbole from the sell-side, and others interested in promoting Japanese equities, becoming extreme. However, he cautions that "there is not a lot of discussion around the risks to Japanese equities from current elevated levels" and adds that "one observation I would make is that Japan has risen to these levels on a number of occasions over the last 25 years, only to fail spectacularly each time against what is referred to, by some in the Japan markets, as the “Iron Coffin Lid”. History suggests it is far better to be short Japanese equities from these levels than to be long."

So what is this Iron Coffin, why does it have a lid, and what happens next?

Below is a visualization of this "Iron Coffin Lid" effect: it shows the key resistance level in the Topix beyond which the index has failed to progress every time in the past quarter century.

There"s more than just a chart however: here is Horseman"s take on why this latest rally in Japanese stocks is also set for disappointment.

For those unwilling to outright short, I would point out that historically Japan has had meaningful underperformance following past bursts of outperformance. In these periods it is particularly appealing to short against longs in higher growth areas. Japan also provides amplified short returns during global down turns. As such it can be a low cost but high return hedge to risk-off impacting long positions elsewhere. One way to identify when Japan is about to provide its greatest periods of underperformance is when its market capitalisation exceeds its Gross Domestic Product (GDP). Again, on this measure history suggests it is far better to get short Japanese equities at current levels than to get long.

 

 

One way to think about Japan’s persistent underperformance is that past market rallies have been quickly frustrated by structurally weaker GDP growth, as opposed to other markets with more sustainable growth. Japan’s GDP only grew +1.7% over the last 10 years, a CAGR of +0.169%. It grew even less in the 10 years prior. It is no mere coincidence that the market has failed to break out during decades of weak economic activity. Once again the market is pricing in significant economic expansion to come in Japan but its demographics, the key reason for past structural weakness, are only getting worse. I expect the euphoric hope held by many in the market, that “this time is different” in Japan, will once again be crushed by the “Iron Coffin Lid” that is Japan’s structurally weak economy. Long positions in Japan will likely be buried alive again while short opportunities thrive. Yes, Japan’s GDP growth rate has been higher since 2012, during what I would consider a recovery phase. But the drivers of growth in the three largest components of GDP growth are unsustainable, exhausted and now showing clear signs of reversing. Our market views to be released over coming days will look into these three major components of recent GDP growth in more detail.

Originating from Horseman Capital, hardly known for its optimistic outlook, here is the fund"s take on why Japan is set for more pain once the current euphoria fades, and how to capitalize on this imminent decline:

As a short preview, Japan faces immense risks to its economic system from;

 

1. Declining private consumption as the number of households in Japan starts to decline. Nowcast data also shows a marked decline in household consumption in recent months.


2. A precipitous decline within the financial sector, an often forgotten component of GDP. With the Japan Financial Services Agency now reporting that most regional banks have become loss making in core businesses.


3. A roll-over in the real estate sector as residential oversupply hits, vacancy rates rise, rents fall, prices decline in some areas and contract ratios indicate more price cuts are coming.


4. Net export growth, which has been driven by a weak Yen and weak oil prices, faces a risk of the Yen strengthening 22% back to the long run real effective exchange rate, as well as continued oil price rises.

 

Short opportunities in regional banks, real estate developers, Real Estate Investment Trusts (REITs) and mid-size retailers are particularly appealing. The first three of these sectors, about which we have written over the last two years, have been noticeably weak but still offer significant downside. The retail sector, about which we have only recently began to write, has yet to turn down but was a notably weak performer in the last years of the last global  credit cycle. Importantly we believe that shorting these sectors does not require an end to the global credit cycle, but they would likely generate amplified short returns in that environment and hence afford excellent hedges to other longs elsewhere.

Finally, it"s worth recalling that as of one month ago, the BOJ already owned three quarters of all Japanese ETFs: a number which is now certainly higher, and is a non-trivial reason why Japan"s stocks have enjoyed the recent surge. Of course, with ETF supply declining rapidly and the BOJ soon to be locked out of further purchases, the question is what will stoke further "flow" into risk assets (and frontrunning of central bank purchases), and will the BOJ expand its mandate further to buy single name stocks next in the name of "price stability?"

 

Japan Is Booming! (Except It"s Not)

Authored by Jeffrey Snider via Alhambra Investment Partners,

Japan is hot, really hot. Stocks are up to level not seen since 1996 (Nikkei 225). Prime Minister Shinzo Abe called snap elections in Parliament to secure a supermajority and it worked. Things seem to be sparkling all over the place, with the arrow pointing up:

“Hopes for a global economic recovery and US shares’ strength are making fund managers generous on Japanese stocks,” said Chihiro Ohta, general manager of investment research at SMBC Nikko Securities.

Only that isn’t real, just like it wasn’t three or seven years ago. Emotions don’t seem to be tracking well with reality, and in Japan it is no different. There isn’t even much of lingering popular belief in QQE to at least give these broad feelings the appearance of substance; global growth is coming because, well, it just has to, right?

Like here, or anywhere for that matter, stocks are up but the economy is not. Belief still clings to what is always over the horizon. You would think given the breathless coverage in the worldwide media that Japan is utterly booming, jumping with so much activity the island can’t contain it all. It just isn’t true, the story being wildly distorted as always to fit the (technocrat friendly) narrative.

Household spending in Japan, for example, has turned slightly positive in the past few months. It sounds like more than it is, less of a positive than in the middle of 2015 when all the same things were being said about the subject by the same people. Like anywhere else, even the Japanese economy is prone to the occasional upturn. What really matters is that those brief moments of positive never come close to making up for the more widespread and sustained negatives.

It’s another relative change that is mistaken, quite often intentionally, for a categorical one. In other words, Japan is experiencing little more than a reprieve from continued contraction rather than any actual turn toward actual growth.

That verdict is given to us by Japan’s labor market. The more positive anyone is about the economic circumstances there, the more likely it is that the labor market shows the opposite. Total hours worked continue to decline despite the rise in relative activity (again, proving its relative not categorical).

Wages that had looked seemed like they were on the rise really were impacted more by base effects and statistical irregularities (the transitory rise, then fall, of the CPI) than anything tangible. Real wages have contracted year-over-year in each of the past three months, and have been zero or negative in ten of the last eleven. And still economists point to Japan’s unemployment rate as if it matters.

But because the media is selling the future of “global growth”, the charade will/can only continue:

A hefty win raises the likelihood that Abe, who took office in December 2012, will secure a third three-year term as LDP leader next September and go on to become Japan’s longest-serving premier. It also means his “Abenomics” growth strategy centered on the hyper-easy monetary policy will likely continue.

It’s the appearance of hyper-easy monetary policy, not actual or effective accommodation. No matter how many times the other is claimed and will be claimed, that doesn’t just make it true. In Japan, like everywhere else in the world, there isn’t the slightest hint that QE, QQE, or QQE with YCC underwrites even a little positive economic difference. Japan’s small upturn has nothing to do with QQE and everything to do with minor (and relative) “reflation” after the “rising dollar.”

At now more than half a quadrillion yen on its books, both sides assets and liabilities, obviously, what is the Bank of Japan’s QQE actually doing? It has been reduced to questionable histrionics, the necessary part of every media story on Japan that makes it seem like authorities are doing something helpful.

I believe instead that Abe’s successful election gambit is somewhat of a parallel to other political processes being played out in places like Austria, Germany, and even to some degree China. The Japanese people have resigned themselves to this economy as it really is, and pay very little attention to QQE or whatever else like it. They have to know by now that it has made no positive contribution, so why not vote on the basis of other matters if the grand economic designs that swept Abe into office the first time in 2012 can’t move the needle after five years.

Abenomics or not Abenomics, there has been no difference. The economy is as bad or worse than it was before, and it doesn’t look like either party will do anything that can change matters. Therefore, increasingly, other issues become the centerpiece for what is really economic dissatisfaction channeled into alternate formats.

Earlier this year, in the face of an increasingly hostile North Korea, Abe set a deadline of 2020 to revise Japan’s constitution, which contains language that bans the country from maintaining armed forces. It is a controversial proposal that strikes at the heart of the country’s post-war identity.

If that post-war identity includes hapless technocratic monetarism, then why not change it if only to be able to change something? Maybe the Japanese do have a limit, and that a quarter-century is more than enough of one feckless scheme after another. The old way of doing things just doesn’t work anymore, a judgment that is being applied all across the world. North Korean or Chinese provocations suddenly matter more now perhaps because the Japanese worry about Japanese strength in economic terms.

It’s almost political contagion, where people in Japan or the UK see others voting for “that’s enough” and want to make the same bold, dissenting statement however they might. You vote for something very big and very different because there is no vote on monetary or economic protest that either political party will give you. It explains quite a lot, including the backlash against the backlash.

The world is treading a dangerous path primarily because the official parts of it won’t admit there is a problem; or, in places like Japan, that they might not have the will and understanding to do anything about it. It’s the worst part of this zig zag, where nothing, even stagnation (depression), ever goes in a straight line. Each of these all-too-brief upturns are always mischaracterized as far more than they ever could be, and so any urgency about addressing the real issue falls by the wayside.

The growing unrest doesn’t, of course, and instead gets funneled into often unproductive directions. We collectively look in the wrong place because the right answers are really hard to see.

USDJPY Inches Higher As Japanese Stocks Set For Longest Winning Streak In History

Yen is weaker and Japanese equity futures notably higher following a landslide election victory for Japan Prime Minister Shinzo Abe which theoretically ushers in yet more easy monetary policy. USDJPY has jumped above 114.00 in early trading, sending NKY futures up almost 1% in the pre-market.

If this equity rise holds it will mark the 15th consecutive gain for the Japanese market - breaking the 1961 record of 14 straight days to become the longest winning streak in Japanese stock market history.

Nikkei 225 is at its highest since Dec 1996.

Meanwhile, much has been made recently of the decoupling between USDJPY and the Nikkei 225

However, this chart masks a closer relationship between USDJPY and the relative performance of Japanese and US equities.

So there really is no regime shift.

What are the drivers of this persistent negative correlation between the yen and Japanese equities and which flows supported this negative correlation this year?

On Friday, JPMorgan presented three fundamental explanations to justify the link between Japanese equities and the yen.

One typical explanation is that the yen, being a major funding currency for the world, should rise in a risk-off equity environment and vice versa. But this argument is not supported by the fact that there is much lower correlation between the yen and global equities. It is also not supported by the structural break in the correlation between Japanese equities and the yen shown in the chart above. The yen was the most prominent or sole funding currency before the financial crisisof 2007/08. After the financial crisis the yen was joined by the dollar and later by the euro as funding currencies. So if anything the negative correlation between equities and the yen should have been even more negative before the financial crisis. But the opposite happened. The negative correlation only intensified after the financial crisis.

 

A second explanation, with causality running from yen to Japanese equities, is that a weaker yen has a positive impact on corporate profits inducing equity investors to buyJapanese equities and vice versa.

 

A third explanation is that Abenomics was always thought of as a combined trade for overseas investors: buy Japanese equities and sell the yen. And reverse, i.e. sell Japanese equities and buythe yen, when Abenomics wanes.

But JPM notes both of these last two explanations have a problem: why does the yen not go up as foreign investors buyJapanese equities? In principle when foreign investors buy or sell Japanese equities currency-hedged there should be no currency impact. And when foreign investors buy or sell Japanese equities currency unhedged there should be in fact a positive correlation between the yen and Japanese equities. What are the circumstances then under which we have a negative correlation between Japanese equities and the yen?

We previously presented three flow circumstances:

 

1) If a foreign investor (buyer) purchases Japanese equities currency-hedged from another foreign investor (seller) who was long yen already (i.e. the seller owned these Japanese equities currency unhedged before), the net market impact would be an up movein Japanese equities and a down move in yen.

 

2) If a foreign investor (buyer) purchases Japanese equities currency-hedged from a Japanese investor (seller) and this Japanese investor uses the proceeds to purchase foreign equities currency-unhedged, the net impact would also be an up move in Japanese equities and a down move in yen. This flow appears to have taken place since mid-September. Foreign investors were buyers of Japanese equities, at the same time as Japanese investors sold domestic equities and as Japanese investors stepped up their purchases of foreign equities. But since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on theyen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow.

 

 

3) Another flow example is related to dynamic hedging by existing holders of Japanese equities, Existing foreign holders of Japanese equities could have unwound previous FX hedges in response to equity price declines in recent months, even if they did not sell any Japanese equities themselves. This is because equity investors tend to dynamically adjust their FX hedges to match the size of the hedges to the value of their equity holdings. So as the price of Japanese equities goes down in local currency terms, these foreign investors cut some of their previous FX hedges, pushing the yen up in the process. The opposite flow takes place in periods of Japanese equity appreciation: existing foreign holders of Japanese equities have to increase the size of their FX hedges to match the increased equity values, pushing the yen down in the process.

This dynamic hedging flow suggests that there should be an even stronger correlation between the performance of the yen and the absolute performance of Japanese equities in local currency terms, relative to the correlation between the yen and the relative performance of Japanese vs. US or global equities. But the two charts above show that the opposite happened this year. The correlation between the yen and the relative performance of Japanese vs. US equities has been stronger than the correlation between the performance of the yen and the absolute performance of Japanese equities. This suggests the above flow stemming from dynamic hedging by foreign investors of existing Japanese equity holdings, has likely weakened this year.

So from the above three flow circumstances, it is the second one that appears to offer the best explanation of what happened since September in the Japanese equity/yen space. 

So, following the recent buying, how overweight have foreign investors become in Japanese equities?

So in all, it appears that overweights in Japan have been focused mostly among leveraged overseas investors including CTAs, making Japanese equities vulnerable to an unwind of some of these positions in the near term. Non-leveraged institutional investors or retail investors are rather neutral.

To conclude, JPMorgan finds no reason to believe that the historical negative correlation between Japanese equities and the yen has broken down. The relationship between Japanese equities and the yen has been closely aligned this year if one looks at the relative rather than the absolute performance of Japanese equities.

More recently, since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on the yen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow. Going forward, overseas leveraged investors present the main vulnerability for Japanese equities, in our view.

Gold, VIX, Bitcoin Surge; Stocks, USDJPY Tumble After North Korean Missile Launch

Dow futures down over 120 points (and Nikkei 225 down over 200 points) at the reopen following North Korea"s "successful" firing of a ballistic missile across Japan.

Gold futures spiked to $1325 as USDJPY plunged...

The USDJPY is tumbling on the news... Breaking below 108.50, a break of April"s 108.12 may require more than a little help from Kuroda and friends.

Japanese equity market futures plunged to 4-month lows...

And VIX futures are snapping higher...

How To Hedge A Near-Term Market Shock: Here Are The Best Trades

As we showed earlier today, last Thursday"s unexpected, historic VIX explosion, driven by a surge of geopolitical worries about North Korea, and subsequent collapse was remarkable in both how fast and furious it was both on the way up and then, on the way down.As Bank of America said "both the spike in vol and the speed of its retracement were almost unmatched."

The move was also unprecedented in the sheer volume of VIX-related products - futures, options and ETFs - that participated in the surge higher as thousands of vol sellers suddenly scrambled to cover their positions (even if they were ultimately replaced with a new set of vol sellers). As BofA calculated, "volume in VIX-linked products reached an all-time high" with volume in VIX call and put options reaching a $250M
vega. VIX futures also had a record volume day with $850M while VIX ETP volumes hit $830M.

 

In retrospect, the biggest surprise about last week"s move - especially considering the loud warnings by famous Wall Street names such as Jeff Gundlach and Howard Marks predicted such a move - is how many people were taken by surprise by it. Or maybe they were not surprised, but just did not want or know how to hedge.

As Bank of America"s Benjamin Bowler writes, "most people ignore extreme risk as it’s simply too hard to price." One possible reason is because deciding whether to hedge tail risks is difficult not only because of the challenge of estimating the probability of a “rare event”, but it’s also compounded by the difficulty of gauging the size of the shock, if the event occurs. This is likely why a majority of cross-asset volatilities remain near historical lows despite the threat of a nuclear conflict becoming most acute perhaps since the Cuban missile crisis in 1962, according to Bank of America.

And yet, if the events from last week demonstrated something, it is that just when there appears to be virtually no risk, is when the likelihood of a historic surge in volatility is greatest, as many experienced first hand last Thursday. Hence the need to hedge.

But what?  And using which product?

Because, as Bowler also shows when it comes to discounting the probability of the next severe market shock, virtually every derviative product has a different perspective. As the strategist notes, "the decision about whether it’s rationale to hedge is really a matter of looking at the price of tail insurance embedded into option markets and asking if the probabilities they assign are “fair” or not." As he further writes, when it comes to predicting what the next "severe tail event" could look like, "we find that not only are some markets like Gold pricing in a very low probability of Korean risk escalation, there are significant differences across assets in terms of what they imply about potential risks."

The chart below shows how historical worst 3M drawdowns since 2006 are priced by 3M 25- delta options across asset classes; hedges that are most underpricing their historical drawdowns are at the top and those most overpricing their tails are at the bottom. What the chart shows is that gold call options still imply less than a 1 in 100 chance of a severe tail event over the next month, despite being among the most reactive assets to rising Korean tensions last week. With record low Gold vol slaved to record low real rates vol, this represents a loose anchor which likely won’t hold in any significant geopolitical risk escalation. In contrast to gold, Nikkei is at the other end of the spectrum with options assigning over a 5% chance of a near term tail-event.

Looking at 3M 25-delta options, however, may not be the best measure of the price of “rare event” risk priced into options.

As BofA suggests, "to get a better understanding of this implied risk for six assets – Gold, S&P 500, NKY (Japan equity), KOSPI2 (Korean equity), UKX (UK equity) and SX5E (European equity) – we estimate what options are pricing into their extreme tails using the following methodology:"

• For each asset across its entire sample history, we identify the ten largest “vol-adjusted” drawdowns within 1-month periods. The reason for normalizing by volatility is that we have shown that while nominal asset drawdowns can significantly vary historically, vol-adjusted drawdowns are more evenly distributed. In other words, the probability of a 1-day drop in the S&P 500 equivalent in magnitude to the 1987 US stock market crash (-21%) is virtually zero at today’s low vol levels. So for each historical drawdown, we adjust for the prevailing vol level and assume we were to see a similar “sigma-drawdown” today.


• We then compute the probability that options are assigning to markets falling to (i) their 10th worst historical drawdown and (ii) the average of their 10 worst drawdowns in each asset (as shown in Chart 10).

BofA"s analysis confirms that Gold is indeed pricing in the smallest probability of a “tail event”. The implication also is that should a "tail event" occur, the return from a gold-based hedge would be the one with the highest return.  Here are the details:

• As implied from Gold (GLD ETF) options, the probability that Gold rallies over the next month by 10.3% (equivalent to the 10th largest vol-adjusted rally in Gold’s history) is 1.7%. The probability that Gold rallies by 14.6% (equivalent to the average of the 10 largest vol-adjusted rallies) is a mere 0.7%. This suggests GLD calls are implying less than a 1 in 100 chance (1 out of 143) of its average historical tail event occurring in the next month.


• At the other end of the spectrum is NKY, where options imply the probability that Japanese equities fall by 8.2% (10th largest drawdown) over the next month is 6.1% and the probability they fall by 10.4% (average of 10 largest drawdowns) is 5.1% (1 in 20 chance).

In other words, just between gold and Nikkei options, the "priced in" probability of a crash is either ~1% in the case of gold, or 5% in the case of the Japanese Nikkei.

What about S&P 500 puts? As the chart above shows, they are currently pricing in the second-highest level of  tail risk after NKY, following the strong rise in S&P skew last week. The probability that US equities fall by 7% (10th largest drawdown) over the next month is 4.5% and the probability they fall by 8.65% (average of 10 largest drawdowns) is 3.1%.

* * *

Why is gold such a great hedge to future volatility? One possible explanation for the relative attractiveness of gold-based hedges hinges on gold’s optionality being historically depressed. This has primarily been driven by realized volatility which has been steadily declining since the gold rally in Q1-16 and is now at multi-year lows (Chart 11). An important force behind gold’s declining volatility is real rates volatility.  Indeed, real rates have a traditional relationship with gold through the channel of rational investment decisions, whereby investors measure the relative attractiveness of gold by how much they can earn elsewhere. As interest rates rise, so does the opportunity cost of holding a non-interest bearing asset such as gold.

While the relationship is not linear as not all real rate environments are created equal, and other important factors – such as the USD – impact underlying price dynamics, never before has this relationship has been so strong (see Chart 12). Importantly, real rates volatility itself has fallen to levels unseen since the start of the 2000s. This in turn has caused gold volatility to fall to ultra-low levels as correlation between gold/rates volatilities recently climbed to multi-year highs (see Chart 13).

* * *

What are the conclusion? BofA"s analysis reveals that for those "hedging" an imminent market crash (over the next month) should be aware that the payout ratios of “tail options” is highest for Gold, and lowest for NKY and SPX.

So, for those who believe the above implied probabilities are too low relative to the potential geopolitical risks at hand, buying far out of the money “tail options” may be the best trade. While there is more art than science to deciding on precise strikes and maturities, however, Table 2 below illustrates payout ratios for these six markets assuming 1M options are struck at the 10th worst vol-adjusted drawdown, but that markets fall to the average of their 10 worst drawdowns. In other words, if we get a shock that is worse than the 10th worst historical event but equal to the average of the 10 worst, what is the payout relative to cost of the tail insurance purchased today?

As shown in the table above, deep out of the money GLD calls would offer 56 to 1 payout ratios with this methodology, far more than any other asset, followed by UKX (35 to 1), SX5E (25 to 1), KOSPI2 (9 to 1), SPX (6 to 1), and NKY (5 to 1).

Finally, some parting words from BofA:

We see the escalation of ongoing geopolitical tensions as a very plausible candidate for propelling both rates and gold volatility higher as investors flee to Treasuries and gold (both perceived as ‘safe haven’ assets). Indeed our rates strategists recently recommended accumulating US rate volatility in anticipation of a potential political risk-induced risk-off in September.

"Mystery" Central Bank Buyer Revealed: SNB Now Owns A Record $84 Billion In US Stocks

In the second quarter of the year, one in which unlike in Q1 fund flows showed a persistent and perplexing outflow from US stocks and into European and Emerging Markets, a trading desk rumor emerged that even as institutional traders dumped stocks and retail investors piled into ETFs, a "mystery" central bank was quietly bidding up risk assets by aggressively buying stocks. And no, it was not the BOJ: the Japanese Central Bank"s interventions in the stock market are familiar to all by now, and for the most part the BOJ keeps its interventions local, mostly propping up Japanese stocks, whether the Nikkei 225 or the Topix.

The answer was revealed this morning when the hedge fund known as the "Swiss National Bank" posted its latest 13-F holdings. What it showed is that, as rumored, the Swiss National Bank had gone on another aggressive buying spree in the second quarter, and following its record purchases in the first quarter, the central bank boosted its total equity holdings to an all time high $84.3 billion, up 5% or $4.1 billion from the $80.4 billion at the end of the first quarter.

As reported last week, the Swiss central bank has accumulated foreign exchange worth 714.3 billion francs (over $740 billion) due to its ongoing interventions to depress the Swiss franc, and has "invested" those funds created out of thin air in stocks and bonds. At the end of the second quarter, it held 20% in equities, of which the bulk was in US stocks.

While we are far beyond the point of debating central bank intervention in equity markets (we do want to remind readers that until several years ago, it was considered "fake news" to even mention it, and those who accused central bankers of manipulating stock markets were said to be paranoid tinfoil basement dwellers), we want to point out that unlike the BOJ, which at least keeps its capital markets distortion local, the SNB, which likewise creates money out of thin air (then sells it for dollars in an attempt to keep the Swiss franc depressed) is actively causing substantial price distortions in the US.

While we doubt this will be investigated with stocks are at all time highs, we look forward to the Congressional hearings after the crash when the scapegoating and fingerpointing begins, and everyone is "stunned" to learn that central banks were responsible for blowing the biggest asset bubble the world has ever seen by directly buying stocks.

What else did the SNB reveal in its 13F? Two main things.

First, its top 20 holdings are as shown in the following chart. The central bank was clearly not shy in adding to its top positions, especially the top position, which increased as a result of both appreciation and new purchases.

And while we have yet to learn if Warren Buffett was actively frontrunning the SNB once again during the quarter, similarly to his activity in Q1 when he more than doubled his AAPL stake making him a top 5 holder of the tech giant, a look at the SNB"s holdings of AAPL stock which again increased from 18.9 to 19.2 million shares, making it a larger holder of AAPL stock than Schwab and Franklin Resources (with 18.3 and 17.8 million shares respectively), and just behind AllianceBernstein, shows why the Nasdaq has until recently been hitting new all time highs on a daily basis.

The chart above may also explain why Goldman, despite warning of rising worries about record low volatility remains bullish on the Nasdaq 100: after all, when a central bank can and does create money out of thin air, then splurges on the handful of tech companies that have the biggest impact on the broader market, pushing both the Nasdaq and all indices higher, what is the point of even talking about "risk"?

Source: SNB 13-F