Japanese Politics, Central Banks, and Sterling Outperforms

Japan’s Prime Minister Hatoyama resigned. There were such hopes for the DPJ, but the combination of party scandals and the controversy over the failure to carry out a campaign promise about moving the US Marine Corp base off of Okinawa ultimately proved overwhelming. His resignation and the resignation of the DPJ Secretary General Ozawa, who was also the key strategist and powerbroker leaves the DPJ seemingly rudderless ahead of two key events.

The government was working on a fiscal consolidation plan that was to be unveiled in the coming weeks. This was the report that S&P recently identified as key to its rating decision after putting Japan on watch earlier this year. The weakened political environment makes bold action, which is needed, less likely. And this in turn raises the prospects of a Japanese downgrade. Note that earlier today S&P warned that Japanese regional banks face falling profitability. The poor political climate is underscored that not only has Hatoyama not last a year as prime minister, but the previous three LDP prime ministers did not either. The second key event is the upper house election, expected July 11th. Half of the 242 seats are up for election. The DPJ and their allies are likely to lose their majority, but will retain it in the more powerful lower house. The DPJ will have a leadership contest at the end of the week. Such a short time period would favor those that are already organized. The favorite must be the outspoken Finance Minister Naoto Kan.

Several countries, including Brazil, Russia, India, Japan and South Korea have all come out and said nice things about the euro. As we have argued, reserve managers do not typically react to short run developments. They often move it seems at glacial speeds, with due deliberation and caution. In addition, there is truly little alternative. Since the end of Bretton Woods, it appears that the world, or at least that part that reports the composition of its reserves, feels comfortable holdings 60-70% of the reserves in dollars 20-25% in European currencies (ECU, mark and franc before the euro) and 10%+ in other currencies, including sterling and the yen. Valuation swings would seem to account for the bulk of the volatility of reserves and their composition. That said, it does appear that developing countries have generally speaking a lower share of dollar in reserves than the developed countries. Central banks may not be reducing their euro holdings, suggesting private investors accounted for the bulk of the divestment of European bonds in Q4 09 that has been reported as part of the ECB’s capital account report.

On the other hand, there are some news wires reporting that the Iranians may be an exception and have begun selling off some 45 bln euros. The reports suggest they are buying dollars and gold. It is difficult to verify these claims.

Separately, there are a few other developments in Europe to note. There is some indication that the vote on Portugal’s recently announced austerity package may be delayed today, though there has been no official confirmation. The final vote is expected on June 9th.

In Italy, news that the May state deficit was 8.1 bln euros vs 7.95 bln euros last May could be a factor weighing on Italian bonds today. However, Italian officials note that this figure includes a loan to Greece, without which there would have been some improvement.

Third, UK gilts have recovered initial losses following a successful 5-year gilt auction. A total of GBP4.25 bln of a re-opened 2015 issue were sold. The bid-cover was essentially the same as it was at the initial sale in March of 2.34. There may have been some nervousness ahead of the auction after a German bund auction failed (not enough buyers) last week. Separately, the UK reported better than expected construction PMI (strongest since Sept 07) and mortgage approvals, but disappointing consumer credit figures.