Developments in Europe, UK, Japan and Sweden

Tomorrow’s ECB meeting is drawing attention today. No one expects a change in rates. Instead the focus is on liquidity provisions. A news wire report claiming that the ECB would announce an extension of some facilities.

There is some thought that given the systemic strains, the ECB may want to take additional measures to help smooth the maturation of the 442 bln 12-month repo. Three month Euribor edged to new multi-month highs today. In any event the press report has been denied and in public remarks ECB President Trichet has not revealed anything. On balance, the market may be disappointed if it expects new lending facilities or an extension of some existing ones.

Many pundits have argued that part of Greece’s problem is that it can’t devalue its currency. If it could, the argument goes, it good boost its exports. While this sounds reasonable, the problem is more surely more complicated.

Today’s UK trade figures drive home the point. Since Q4 07, sterling has depreciated 20-25% on a trade weighted basis and it does not appear to have helped exports very much. In fact, net exports were a drag on Q1 GDP. The UK reported an April deficit of GBP7.28 bln sterling, though the March figures were revised to a GBP7.26 bln deficit from GBP7.52 bln. The non-EU-trade balance came in just under GBP4 bln and this March series was also revised to show a slightly smaller deficit.

April UK data may have been distorted by the disruption in air traffic due to the Icelandic volcanic ash. This may impact other countries’ trade performance in April and not just European countries. Suppliers of fresh fruit and flowers, for example, from the Middle East and Africa are also likely to have been impacted. However, the larger point that currency depreciation does not necessarily lead to trade improvement still seems a fair observation.

Japan’s new finance minister wasted no time in making comments about the foreign exchange market. Noda acknowledged that disorderly moves adversely impact the economy.

More importantly he tried to play down the weak yen bias of the Prime Minister by seeming to promise not to guide foreign exchange rates in either direction. Yet this seems a bit disingenuous. Just yesterday, Prime Minister Kan said that in a general sense a weak yen is positive for the Japanese economy. But here too there is more than meets the eye. Japanese exports are not what they used to be. MOF data suggests that for the last decade, the sales by foreign affiliates of Japanese companies exceed exports. Most of the Japanese cars, for example, that American will buy this year will be made in the US.

Yet there is another channel in which a weak yen is helpful for Japan. Japan has the largest net international investment surplus. This is to say that Japan owns much more foreign assets than foreigners own of Japanese assets. In the current account figures that were released yesterday, the income Japan earns from these overseas investments again surpassed its trade surplus. The composition of Japan’s current account surplus has changed. It is increasingly driven by the investment income account more than the trade account. As stronger dollar and euro, would make its foreign earnings to convert to more yen.

Separately, note that Japan reported a much stronger than expected 4% rise in April machinery orders. This was a little more than twice what the market had expected and follows a 5.4% increase in March. This bodes well for capital expenditures in the coming months.

Sweden reported healthy gains in industrial production and orders for April, but many are not convinced yet that the Riksbank will hike rates next month primarily because of European sovereign woes. April industrial production rose 0.9% after a 4.1% gain in March. The year-over-year rates increased to 7.3% form 6.7%. Orders rose 0.7% and are 17.6% above year ago levels. Surveys of inflation expectations have crept up. Last week euro fell to its lowest level against the krona since late 2008 (~SEK9.5090). It rebounded Friday-Monday to almost SEK9.70. That seemed to exhaust the correction and the euro slipped back to SEK9.61 today. And this probably denotes the near-term range.

We recognize that next month’s rate decision is a close call, but we see Sweden as among the short list of candidates to initiate a tightening cycle in the coming period.