New Week, Old Drivers

There are four major considerations in the foreign exchange market as August winds down: the trajectory of the US economy, the outlook for US monetary policy, Japan’s policy response to the weakening economy and strengthening yen, and European strains.

There is a general consensus that although Bernanke essentially revealed what in pre-crisis times would have been called an easing bias, actual easing was not imminent. The bar for action was “significant deterioration” of the economic outlook. Such news is unlikely to be forthcoming today when the US reports July personal income and consumption data. Personal consumption expenditures has essentially been flat in Q2, but is expected to have risen 0.3%, the strongest since March. Personal income is expected to have recovered form the flat reading in June to also have risen about 0.3%. That said, there is plenty of scope for disappointment this week with the ISM, auto sales and employment reports.

Anticipation of a policy response from Japanese officials initially sparked a pullback in the yen, not just against the dollar but on the major crosses as well. However, Japanese government officials (whether LDP or DPJ) ability to under-whelm the market remains a consistent theme. At the conclusion of the BOJ emergency meeting, it was announced that the JPY20 bln 3-month bank lending facility would be extended to JPY30 trillion and for 6 months. There was a single dissent (Suda). These measures were anticipated by market observers.

Prime Minister Kan indicated that JPY920 bln (~$11 bln) of the budget reserves would be used to finance more stimulus. The decision to intervene in the government’s (Ministry of Finance) and it is still obviously reluctant to intervene. It is not just that its experience (2003-2004) was not inspiring, but also the Swiss National Bank did not appear to enjoy any more success with its massive operation earlier this year. American and European officials are clearly reluctant to join an intervention operation. That said, if the Japan were to intervene in the foreign exchange market outside of its time zone, it would likely give the funds to the ECB and Fed in which they would use to execute Japan’s instructions. This would not be the same as coordination.

Note that Kan faces a leadership challenge from Ozawa on Sept 14. The early newspaper polls show Kan enjoying as much as a 4 to 1 lead over Ozawa who was forced to resign over a funding scandal involving aides a few months ago. Lastly, tomorrow Japan reports July industrial output figures. Recall that industrial output fell an unexpected 1.1% in June. The consensus calls for a 0.2% decline in the July reading.

European news today has been mixed. The retail PMI fell below the 50 boom/bust level in Aug (49.7 vs 52.4 in July), but the EMU Sentiment Index came in at 101.8, slightly better than expected and a modest improvement over the 101.1 reading in July (was 101.3).

Apparently largely based on recent comments from BBK’s Weber, who still looks to have the inside track to replace Trichet next year, the Financial Times is playing up the likelihood that at this week’s meeting the ECB announces it will extend its extraordinary liquidity provisions into next year. The shorter duration operations (1 week and 1 month) do not appear very controversial. Extending the 3-month facility is somewhat more debatable, but also seems reasonable.

Note that the ECB had cautioned that the EMU rebound would likely peak in Q2 and downside risks reemerge in late H2. In recent weeks, the market has turned less sanguine toward EMU. This month has seen a record monthly rise in credit-default swaps for Ireland, Italy and Spain. CDS prices in Portugal rose this month by the most since April, and in Greece the most since June. While ECB officials may have succeeded in easing the liquidity crisis earlier this year, there remains elevated concerns that solvency issues have not been resolved and the slower growth (in Europe and the world) exacerbates these concerns. Another threat exists for core EMU members, like Austria and Belgium, in the form of eastern and central European exposure.

Harvard economist Rogoff warned that several eastern European countries may have to restructure their debt. He specifically cited Ukraine, Romania and Hungary as “potential wobblers”. While there was little immediate market reaction to the comments, this issue has potential to re-emerge.