Fcous on Yen, Euro, Sterling and Swiss Franc

It does not appear that yesterday’s intervention has been followed with more action today. Some market observers will be suspicious for a bit every time a Japanese bank buys dollars. There was no doubt about yesterday’s operation and it was quickly confirmed by officials. Strong domestic pressure was brought to bear on officials for the intervention.

The Kan government needs to show it is responsive. There may be a time and place for strategic ambiguity, this not one of them. Officials are claiming success for their unambiguous operation. It seems to have been fairly expensive for Japan. The Nikkei reports, with citing sources, that intervention yesterday was a single-day record in excess of JPY2 trillion (~$23.3 bln). This would be above an informal survey of estimates which were largely in the $10-$20 bln range, which is something on the magnitude of 10-15x more than the initial reports coming from Tokyo had suggested. There has been some official suggestion that the BOJ will use the funds to provide market liquidity suggests the intervention will not be sterilized (offset by issuing financing bills). The BOJ did skip its money market operation. The initial read of money market conditions would be consistent with intervention in the JPY1.75-JPY1.85 trillion range.

The euro is at its best level since August 11. It has successfully overcome the offers near $1.3050 that had capped it in recent days. The euro has now rallied a little more than 3% over the past five days. New focus on the talk of large scale asset purchases by the Fed seems to have coincided with the greenback’s fall out of favor.

The channel of transmission here is the interest rates. One of our consistent themes has been how well the euro tracks US-German two-year interest rate differential. We noted in recent days that the spread had begun widening out again in Germany’s favor. In the past five days, that spread has nearly tripled from 13 bp in Germany’s favor to 35 bp today. This is a new high for the year. In the current environment, this is an unambiguous dollar negative development. The euro’s technical tone is also constructive and is also consistent with a move back to at least last month’s highs near $1.3335.

The economic news in the UK continues to disappoint. While the market buzz has focused on the possibility that the Fed renews asset purchases, the UK seems more likely to do so. The stubborn inflation data (yesterday) and the uptick in the BOE’s inflation expectations survey (to a new 2-year high (3.4% on a 12-month view from 3.3% at the last survey in May) is the main obstacle, but the economic data stream could not be worse.

Recall all three PMIs for August were below expectations. The trade deficit is considerable wider than expected. The labor market is softening. And today the UK reports a 0.5% decline in retail sales in August compared an expected 0.3% rise. This is the first monthly decline since January and the decline seemed widespread. Moreover, adding insult to injury the July series was revised to 0.8% from 1.1%. Tax increases and spending cuts are coming. The weaker dollar tone, however, may be concealing the sterling’s vulnerability. Against the dollar, we note that the 5-day moving average crossed above the 20-day moving average yesterday for the first time in a month. We find these averages to be useful in indentifying the underlying trend. Cable needs now to push through the offers in the $1.5650 area to open the door for another cent or two to the upside. However, sterling is likely to under-perform the euro. There is a bit of a battle being waged over the GBP0.8400 level. A convincing break could see at return to the July highs near GBP0.8530.

As this is being written, we await the outcome of the Swiss National Bank meeting. At the start of the week, the market focused on a call from a Swiss bank that the SNB would tighten policy. Most participants doubt this and this may be a weight on the Swiss franc. The most likely scenario now seems to be that the SNB does nothing but revises up its economic forecasts, like the government did earlier today.

Next year’s GDP forecasts may be more telling than this year’s, as Q1 and Q2 GDP were stronger than expected. The government cut 2011 GDP forecast to 1.2% from 1.6%. If the SNB concurs this might not be the stuff that makes for monetary tightening, especially given the CHF strength and downside risks on inflation.