Japan Update

There are three developments in Japan to note: political compromise over the retail sales tax hike, outcome of BOJ meeting and economic developments. Despite some press reports playing up the likelihood of official intervention, we continue to see the odds as slight. The dollar-yen exchange rate remains confined to a JPY78-JPY79 trading range. 

While the euro has recovered around 4% against the yen in since late July, we expect a return to the lows as the European debt crisis remains unresolved (and arguably unresolvable in the near- to intermediate term).

1. A deal was struck late in Tokyo today that secures the LDP and New Komeito parties support for Prime Minister's retail sales tax hike in the upper house of the Diet. Elections will be called shortly after the bill passes. No specific date has been announced, but a fall election looks likely.

The LDP had helped secure Noda a majority in the lower house, which has already passed the measure. However, most recently the LDP was threatening a vote of no-confidence unless Noda provided a more concrete timetable for election.

Noda has been PM since last September and he spent his political capital on the retail sales tax hike, which the rating agencies like and say is necessary to begin restoring fiscal credibility. However, Noda's support has plummeted and an Asahi poll earlier this week shows his support slipped to 22%, the lowest of his tenure. The DPJ holds a party conference in late September. Noda's term has DPJ head expires then and he will surely face a leadership challenge.

There has been some talk that the possibility of a no-confidence vote had weighed on JGBs. The 10-year and 30-year yields reached their highest in a month today ostensibly on concern the tax hike would not pass.

2. The BOJ's two-day meeting concludes tomorrow. We do not expect a significant change, but do recognize that its asset purchase scheme is having some operational issues and some modest adjustment would not be surprising. In particular, the minimum bid for outright purchases, currently at 0.1% for outright JGB purchases may be cut as the BOJ has failed to draw sufficient bids for its 2-3 year bond purchases.

While recognizing that the yen has been strong and the frustration of Japanese policy makers and businesses, we do not think a compelling case exists for material intervention in the foreign exchange market. The market is not disorderly, as measured by 3-month implied volatility, which stands at the lower end of where it has traded for the past four year (~7.6%). In the options market, the risk-reversals show a small premium for dollar calls over puts, which is unusual, but not necessarily showing a significant market imbalance. It is true that the gross long speculative position at CME has trended high, but at 55k contracts, it is near the middle of this year's range, meaning it is not extreme (just above the 1 and 2 year averages).

In addition, the BOJ, which finds as we do that there exists a good relationship between the US-Japanese 2-year interest rate differential and the dollar-yen exchange rate, should find comfort in the sharp rise in that spread. It late July it stood at 10 bp. Today it is near 18 bp, the highest in a month. The 10-year differential reached 85 bp yesterday, it widest since late May.

3. The Japan's current account surplus rose to JPY433 bln in June from JPY215 bln in May. On the current account basis, Japan recorded a small trade surplus (JPY112 bln) in June after a (JPY848 bln) deficit in May. The decline in oil prices allowed Japan to record its first decline in imports since 2009. The investment income balance remains solid at JPY1.21 trillion after JPY1.05 trillion in May.

Many observers fear that game changer for Japan is when it runs a sustained current account deficit and requires foreign savings to supplement the declining domestic savings. Yet this does not seem imminent or an important market factor.

That said, there is some concern that as the reconstruction efforts ease, the government's support for the economy wanes. In fact, the next string of economic data, including machine tools and industrial production (final) figures are likely to be soft. Next week (Aug 12) Japan reports preliminary April-June GDP. Real GDP growth is expected to be around half of Q1's 1.2% quarter-over-quarter pace and the July-Sept quarter is likely to be slower still.