Greenback's Two Legs and Developments in Japan

I have argued that the dollar’s rally stands on two legs. The first leg, arguably the bigger of the two, is negative developments elsewhere in the world. While the European debt crisis is the most obvious consideration; it is not the only one. China’s incremental removal of excess liquidity and concerns of an unsustainable rise in real estate has deterred investment there. There appears to have been a shift away from cross border equity investment toward fixed income investment and dollar bonds, not just issued by US names, have drawn interest.

The second leg upon which the dollar’s gains rest is favorable developments there. The US manufacturing ISM reached its highest level in six years; the US posted its second consecutive quarter of above trend growth and continued improvement in the labor market is expected to be reported at the end of the week. The latest senior loan officer survey by the Federal Reserve, released yesterday showed some modest improvement in conditions.

Trying get a handle on shifting relationships, our hypothesis is that the risk-on /risk-off framework that was the dominant driver of the global capital markets is giving way to a new matrix based on growth differentials and the closing of the output gap. Thus the bad news in Europe means that its output gap may widen before narrowing, for example, while the US growth data suggest the output gap is closing albeit slowly. The dollar index, which many use to monitor the dollar’s move in general, even though it is heavily weighted toward Europe, is posting a new 2010 high today.

Contrary to market rumors, Fitch did not downgrade Spain’s credit rating, but our work strongly suggests that its AAA rating is well too optimistic. A downgrade is a matter of time. A New York Times article focuses on the challenges faced by Spain. While both Greece and Portugal are relatively small economies, Spain, of course is substantially bigger. Although its macro-fundamental condition is different, the similarity lies in the funding requirements and the lack of a truly competitive economy.

German government sources and other observers are now claiming that the EU/IMF package will not be sufficient to meet all Greece’s funding needs and there is talk that the EU/IMF plan was partly predicated on Greece returning to the capital markets over the next three years. Meanwhile, the public backlash against the austerity measures unfolding with numerous protests and stoppages today. One piece of good news for Greece comes in the form of reports suggesting that a Middle East country is interested in a $6 bln liquefied natural gas project.

The Tokyo markets remain closed for the Golden Week holidays, but there have been two important developments in Japan. S&P, which had reduced Japan’s credit outlook to negative back in January, warns that there is a growing urgency for Japan to cut its deficit. The government plans on unveiling its new fiscal plan next month and S&P indicated that it was important for its credit review. However, Prime Minister Hatoyama is in weakening political position. He had previously staked his political future on re-locating the US Marine Corps base in Okinawa.

On local TV today he was seeking a compromise with the people in Okinawa. However, last month’s demonstration by an estimated 90k Okinawans suggests they are not inclined to compromise. The Social Democratic Party, which is in a coalition with Hatoyama’s DPJ has threatened to pullout if the base is not moved off of Okinawa. Public support for the DPJ in general and Hatoyama in particular raises questions whether the DPJ can hold on to the upper house in the coming election. Moreover, without a strong fiscal plan, it is possible that S&P could cut Japan’s credit rating prior to the July election.