Tankan and Beyond

The European debt crisis has commanded investors' attention. The yen appears to have been largely sidelined. The dollar has been confined to exceptionally narrow trading ranges against the yen and 3-month implied volatility has ground lower and now is within striking distance (within 0.5%) of the multi-year low set just before the earthquake struck.

Supply disruptions and the rise in commodity prices are doing for Japan what policy makers have failed to do and that is arrest deflation. Core CPI (excludes fresh food) turned positive in April for the first time in two years and it is likely to have remained positive in May. Excluding fresh food and energy, the loosening of the deflationary grip is also evident. The year-over-year rate is likely to be zero in May having been as low as -1.6% a year ago.

Japan also releases the Tankan, the most authoritative survey of Japanese business. The headline numbers are likely to show a major deterioration of sentiment, but we advise not paying to much heed to these as they will be reflecting dramatic shock that hit the economy. Instead, we suggest focusing on the forward looking components, including expectations for the September Tankan.

May industrial production figures give some reason for optimism here. There was a 36% surge in transportation equipment output, helped by autos and auto parts. Electrical machinery and the auto sector may be key in the Tankan survey as well. Note that US imports from Japan fell nearly 20% in April and the supply chain disruption may have weighed on the US economy in Q2 as auto inventories were drawn down. This was also likely one of the key factors behind the rise in auto prices (seen in both the PPI and CPI).

In the March Tankan, the large manufacturers expected the dollar to average JPY84.20. It is likely to be cut here in the June survey and a forecast for a stronger yen (dollar below JPY83, for example) may reduce some pressure for intervention. However, we have argued it is more about volatility than level.

Any strength in the forward looking components of the Tankan are unlikely to change the political dynamics in Japan or extend Prime Ministers Kan's tenure. He will likely step down in August. It is not clear at this juncture who will replace him. There is some concern that the DPJ itself may splinter, allowing the LDP to move back into ascendancy.

The Nikkei was the worst performing G7 equity market in H1 11, losing about 4%. The broader Topix was off 5.5%. Foreign investors bought about $42 bln worth of Japanese shares in the first five months, but have since pared back their holdings, perhaps in part because of the absence of gratification. This buying did not seem to drive the dollar-yen rate. Strength in the forward looking components of the Tankan may boost confidence that a recovery is taking hold and this could see the Nikkei test the 10,000 again in early Q3. Meanwhile the backing up of US rates relative to Japan's (18 bp wider 10-year spread over the past five days) could help the dollar solidify a floor around JPY80.