Japanese Inflation and Fed Speculation Dominates ahead of Weekend

The US dollar is trading near its worst levels for the week in mostly quiet turnover. The yen is displaying independent strength and has now eclipsed the New Zealand dollar as the strongest of the major currencies this week with a 2.1% gain against the dollar. Sterling, which had been lifted to a month high yesterday on the back of the constructive Q2 GDP report, is actually the weakest performer against the greenback this week, gaining slightly less than 0.9%.

The yen's strength seems a bit ironic. We learned yesterday that Japanese investors have bought foreign bonds for the third consecutive week and earlier today we learned that core inflation (June) turned positive for the first time since April 2012 and at 0.4%, the fastest pace in five years. The combination of greater capital outflows and higher inflation would have weighed on the yen, not lifted it.

The dollar is trading at its lowest level against the yen since July 11 and it has approached its 100-day moving average (~JPY98.45) for the first time in a month. This also corresponds to a retracement objective of the dollar's recovery off the JPY93.80 low set in mid-June. The next retracement target is seen near JPY97.65.

The strength of the yen weighed on the Japanese shares, where the Nikkei tumbled 3%, led by financials (-4.2%) and technology (-3.6%), though no sector escaped the carnage. Before today, the Nikkei was nearly flat on the week and the 3.2% decline over the past five sessions is the most among the major markets. On the other hand, Japanese bonds are firm and the 10-year yield has held mostly below 80 bp this week, which was the previous floor.

Most of the rise in Japanese prices is coming from fresh food and energy and appears to be a reflection of the weak yen pushing up import prices rather than a break domestic deflationary forces. Excluding fresh food and energy, Japan's consumer prices were -0.2% year-over-year in June, while the same measure for Tokyo in July was -0.4% (unchanged from June).

The other main talking point is about the Federal Reserve. Here two stories have emerged. The first is about next week's FOMC meeting. It is too early, especially given the recent data, for the Fed to harden its timetable for tapering. However, as we have argued previously, in an effort to drive home the point that tapering is not tightening, the Fed could change lower the unemployment threshold to 6.0% from 6.5%. This would effectively push out further in time, expectations for the first Fed funds hike. After a Wall Street Journal article, this issue has come back to the fore and is a more general talking point.

The other story that has emerged this week and remains a subject of speculation is Bernanke's replacement as Chairman of the Federal Reserve. Vice Chairman Yellen had been recognized as the leading candidate, though of course other names were floated. A Washington Post story this week played up the candidacy of Lawrence Summers. Several Senators have written a letter expressing support for Yellen. Most of the commentary in the traditional media and the blogosphere have also argued in favor of Yellen, but the speculation continues.

With Summers' skepticism of the merits of QE being recycled, he has emerged as the more hawkish candidate, while Yellen is seen as the dove, who, at times, has appeared more dovish than Bernanke. Since this story emerged as a talking point, we have suggested that upon closer examination of expertise, temperament and track record, the superiority of Yellen's candidacy will ultimately carry the day.  

Separately, there are a couple of other developments to note.  First, following the more hawkish than expected RBNZ statement, the market has moved to discount about half of a 25 bp hike in January.  Today, the New Zealand dollar is consolidating yesterday's gains.  A close above $0.8065 today will give likely signal a further advance in the days ahead and our next target is near $0.8180.  

Second, Japan and Singapore appear to have reached a deal that will give Japanese banks operating in Singapore access to the local currency from the Monetary Authority of Singapore, using Japanese government bonds as collateral.  This is similar to an agreement struck with Thailand in 2011.  There does not appear to be as much fanfare over this as if China had reached such an agreement.  

Third, as discussed in the Deep Dive: Surplus Capital Revisited post here earlier this week, China suffers from extensive excess capacity and redundant investment.  Chinese officials have announced ambitious goals now.  They have ordered more than 1400 companies in 19 industries to consolidate and get rid of excess capacity.  The goals seem too ambitious to be truly credible.  Consider that the companies have been given until September to idle the excess capacity and eliminate it by the end of the year.   Even if the goals are not achieved in full, the attempt will likely adversely impact economic activity.