Fed Outlook, BOJ and China

The key event of the week is the FOMC meeting.

While no change in rates is expected, speculation has focused on two other elements. The first is a downgrade of its economic assessment. This seems eminently reasonable given the data stream and recent comments by Fed officials. The second is renewing asset purchases and here the focus has been on taking proceeds from its mortgage bond holdings (from early pre-payments and maturities) and purchasing more MBS. Some observers think the July jobs data makes it more likely.

Yet the Fed is likely to see the jobs data as disappointing but not disastrous. The work week expanded and hourly earnings rose. Manufacturing added jobs (nearly 3-times more than expected) as did the service sector. Forecasts for growth here in Q3 was unlikely to be substantially impacted from the jobs report. To be sure there are some worrying signs, but in hindsight it looks like March and April period (when the US private sector grew 400k jobs) looks like the outlier more than recent months. If those two months are taken as exceptional, than the 71k growth of private sector jobs is the fastest of the year and is nearly as much as May and June combined (82k).

The Fed may underscore its commitment to do more if necessary, without committing itself to a particular course. If they do decide to do something, buying MBS appears the path of least resistance because it is treating it like it treats its US Treasury holdings, but the actual material impact is likely to be little.

Lastly, another issue that Fed-watchers must consider is the dissent. Given the fact that growth and inflation are below desired levels, it is possible that Hoenig does not renew his hawkish dissent. On the other hand, given his public comments, it is possible that Boston Fed President Rosengren casts a dovish dissent. If this does materialize, it would put the FOMC in more dovish light than the statement itself.

The BOJ itself appears to be under some pressure to extend its quantitative easing as well. While there has been some talk about this, it does not seem to have captured the market’s imagination. The BOJ regularly buys JGBS, about $18 bln a month in what it calls rinban operations. The DPJ government and especially some of the smaller parties have been pressing for the BOJ to buy more JGBs.

Calls for more JGB purchases are taking place as many participants do not take the risk of actual intervention in the foreign exchange market very seriously. While the MOF decision to intervene is a sovereign choice, many observers who discount it, note that it would not receive the approval of the US. This may play a role in Japanese decision, but it does not appear to be the determining consideration. The large scale intervention the MOF ordered in the late 2003/early 2004 period reportedly did not have the support of US officials at the time. The more compelling argument against Japanese intervention is the likely effectiveness. Without a stronger probability of success, intervention would compound Japan’s embarrassment of riches with over $1 trillion already in reserves. The yen exchange rate is not very volatile. In fact 3-month vol (~11.8%) is below its 100-day moving average ~12.25%) and 200-day moving average (~12.70%).

The skew in the market illustrated by the premium that is paid for yen calls over yen puts equidistant from the forward strike (25-delta risk reversals) are at the lower end of a 3-4 month trading range. In addition, the recent move in the foreign exchange market is more of a dollar move than a yen move. In fact, the euro is at the upper end of its 3 month trading range against the yen and is nearly 6% off the low set in late May.

Ahead of the slew of Chinese data, the yuan posted its biggest advance in a couple of weeks. The 12-month forward now discounts 1.5% appreciation, which is up 0.2% from before the weekend. The yuan has appreciated by about 0.9% since officials announced the dollar-peg would be broken. Recall that under Bretton Woods a 1% range was regarded as fixed. A Japanese news report played up the bad loans of by Chinese banks to local state owned firms. One inquiry found that at much as 20% of such loans, totaling CNY7.7 trilion, might be non-performing. There is some speculation that loan loss reserves will be boosted in the coming quarter.