Today's Outlook

There are two noteworthy developments today: S&P cut Japan's sovereign rating one notch to AA-, citing the lack of a coherent fiscal strategy, and the continued heavy tone of the dollar. The S&P downgrade was surprising especially in the timing. The BOJ had increased its growth forecast for the current fiscal year to 3.3% from 2.1% earlier this week and the government had just reported that exports rose in December for the second consecutive month. The 13% year-over-year growth in exports was well above expectations (~9.3%). The downgrade was announced after the close of local markets, but the impact may be minimal. Foreign involvement in the world's biggest bond market is minimal; recent data suggests no more than 10%.

Moreover, the S&P cut simply brings them in line with Fitch. And when Fitch cut back in May 2009, the dollar rallied for a couple of days and came off. This time, the dollar's gains are considerably more muted, but the yen has been sold on the crosses. On a separate front, note that Japan's exports to the US rose in December, helped by a surge in autos, warning of the risk of some widening of the US trade deficit in December. Japanese exports to China jumped 20% to new record highs. Exports to Europe rose just almost 10%, illustrating the weakness of domestic demand there.

The dollar's heavy tone in general continues. It will not be lost on investors and market observes that the S&P downgrade of Japan came on the heels of the US nonpartisan Congressional Budget Office revised higher its deficit and debt ratio forecasts of the United States. The risk of a US debt downgrade remains minimal, but could weigh on sentiment. The main driver of the dollar's weakness over the part of the past three weeks seems mostly linked to the shift in interest rate expectations and confidence in at least some quarters (such as Germany's largest mutual fund managers) that European officials will solve the debt crisis.

The US discount to Germany on 2-year government paper continues to grow and now stands at its widest level since early 2009. The euro is flirting with technical retracement levels near $1.3740 and a convincing break would encourage expectations of a test on the $1.40 area. Although several German states reported smaller than expected Jan inflation figures, pointing to a sub-2% reading for the country as a whole, hawkish comments ECB's Bini Smaghi about the risks posed by imported inflation and this saw the back-end Euribor futures sell-off.

Meanwhile, sterling has been unexpectedly resilient. It has nearly fully retraced the sell-off against the dollar sparked by the unexpected drop in Q4 GDP. Even today's news, among the first for the month of January, that CBI retail sales report was weaker than expected at 37 down from 56 in December and the outlook for February is even bleaker. Hometrack also reported a 0.5% decline in their home price index for January. This week's news stream has been worth a mild 10-11 bp on both the June and September short sterling futures contract compared with last week's close.

We are somewhat more skeptical than apparently many observers about how close European officials are toward getting ahead of the curve of market expectations. Finance ministers appear to agree not to increase the size of the EFSF, but to close the gap between the guarantees and lending capacity. In addition to trying to win as many concessions as possible, German policy options are circumscribed by domestic political considerations and the vocal opposition by the coalition partner FDP.

While there does seem to be some support in the EFSF buying bonds (directly or indirectly), this seems to be an increasing limited option as EFSF issuance must be recorded as debt and this may overtime undermine the ratings of some countries that are on the knife's edge. For example, our propriety models would show France on the borderline. Also note that while the EFSF raised funds earlier this week at about 2.85%, the rate Ireland will pay is closer to 6%. One key metric of debt/GDP ratios still look difficult to stabilize.