Gaming G7

Over the last couple of weeks we have consistently argued that the European finance ministers were setting up the market for disappointment if the G7 statement does not single out Japan or express concern over the weakness of the yen. We had thought such disappointment would hit the yen hard. However, the price action has been such where we now suspect that the market has sold yen on speculation of disappointment and is vulnerable to a buy on the fact.

Although this may strike some as counter-intuitive, there is a market logic to the argument. Of course, with the Japanese markets on holiday on Monday, there might be a spike down in the yen in early thin trading initially, but this might be better seen as an opportunity to book profits than the start of a new leg down for the yen.

There are a few considerations that also warn of the risk of near-term yen gains. First, Japanese institutional investors frequently sell foreign assets ahead of the fiscal year-end on March 31st. Weekly data from the Ministry of Finance indicates that Japanese investors have already begun selling foreign assets. Meanwhile, the same MOF series indicates that foreign investors have stepped up their purchases of Japanese stocks and bonds.

Second, next week (Febuary 14), Japan reports Q4 GDP. Recall that Q3 GDP was disappointing, dragged down by the weakest consumption figures since the retail sales tax was hiked in the late 1990s. Japan is likely to report a strong rise in Q4 GDP of around 1% compared with a 0.2% increase in Q3. At an annualized pace this is around 4%, which would mean that Japan was the best G7 performer in Q4. Consumption is likely to have rebounded smartly. At the same time, deflationary pressures likely eased. The deflator is expected to be -0.5% after a 0.7% decline in Q3.

Such a strong report may renew speculation that the Bank of Japan may indeed raise interest rates at its Feb 20 meeting. Many, like ourselves, have been surprised by the length of time between hikes, and some have given up on a rate hike in the current fiscal year. Those members of the BOJ board that voted in January in favor of a hike still sound hawkish, while some from the majority seem to be in no special hurry and the market appears to remain closely divided.

Third, market positioning among the speculative community appears to remain deeply short the yen. Earlier it appeared to us that the jawboning of European finance ministers would have produced a stronger bout of position squaring, but the market appears to be positioned for disappointment from the G7. And with the event out of the way, the aggressiveness of the shorts may be re-considered. Indeed given the deflation of market expectations, it would not be difficult to envisage a statement from the G7, which essentially reiterates their old saw about how currencies have a role to play reducing global imbalances. In G7-speak this is to say that the dollar should fall and the Asian currencies should rise.

We had also expected that if the G7 were to disappoint, the Swiss franc would suffer in sympathy with the yen. However, the Swiss franc has been sold off hard. Here too the price action warns that the market may have sold the rumor and may be poised to buy the fact. Over the last couple of weeks, Swiss National Bank officials have sounded particularly hawkish and more concerned about the weakness of the Swiss franc than appeared to be the case a few months ago. That said, the soft Jan CPI (-0.7% month-over-month and +0.1% year-over-year) may have given some participants second thoughts about a March rate hike. It is true that Swiss inflation is below Japan’s, but SNB officials seem more adamant about normalizing. The Swiss economy has generally outperformed the Japanese economy. The Swiss current account surplus stands at almost 14% of GDP compared with Japan’s, which is near 3.5%.

On a knee-jerk spike in early Asia on Sunday, the yen might initially be sold by the Johnny-come-lately types. This could lift the dollar toward JPY122.00 and the euro toward its recent high near JPY158.60, but we suspect the great risk lies in the other direction. If our analysis is right, initially the yen can recover toward the upper end of its recent range. This would put the dollar nearer JPY120 and the euro near JPY155.30.

A similar scenario for the Swiss franc would warn of knee-jerk risk lower, with the euro extending recent gains toward maybe CHF1.6300 and the dollar to around CHF1.2550. We suspect the bigger risk on sell-the-rumor, buy-the-fact scenario would be for the dollar to retest the CHF1.2375 area and the euro returning to CHF1.6150.