Europe Raises Bar, Japan Dithers

The US dollar is narrowly mixed against most of the major foreign currencies as the week winds down.  The big mover is the Japanese yen which is showing some resilience. Initially in Asia, the greenback had extended its recent gains to almost JPY80.40 before reversing to return toward yesterday's lows near JPY79.80.  A break of this area, and especially a close below there, which would trace out a potential key reversal would signal a consolidative or corrective phase has begun.  Such a phase could see the dollar return to the JPY79 area initially. 

The ostensible triggers for the yen's recovery are two-fold.  First, Japanese inflation, really deflation, was a little less than expected, with the September core CPI coming in at -0.1% rather than -0.2%.  Second, as already hinted, the government is proposing JPY422 bln in new fiscal stimulus.  However, on both scores, there is less than meets the eye.

While core national CPI did not fall as much as expected, it is still the fifth consecutive month of negative core CPI readings and the October reading for Tokyo was unchanged at -0.4%.  The underlying details suggest that deflationary forces are still evident.  

There is less to the fiscal stimulus than it may initially appear.  Recall that given the strength of the opposition and the weakness of the Noda government, the stimulus would not come in the form of a supplemental budget, since that would require a new parliamentary vote, but from the reserves of the current budget.   It is not what the Japanese would call "fresh water" but rather more like recycled water.  In addition, it is too small to make a difference.  National Policy Minister Maehara estimated it is worth about 0.1% to GDP.

Neither the CPI, nor the fiscal developments (hard to really call it stimulus) do not remove, but rather add to the pressure on the Bank of Japan to extend its asset purchase plan next week.  Although there is some talk of JPY20 trillion extension, most indications, including the BOJ's modus operandi, seems to favor a JPY10 trillion increase.  There is also some speculation that the BOJ will shift its language from referring to the 1% inflation target to calling it a goal, to further underscore its intent.  

There are three important developments in Europe to note.   First, the bar to tap the ESM may be higher than previously anticipated.  A spokesman for Merkel's CDU party said that the Irish request to have the ESM purchase legacy debt would be considered a new aid package and be subject to new conditionality.  

Germany and the creditor nations have insisted that bad debts held by banks before the establishment of the new supervisory mechanism, that is the legacy debt, will not be covered by the ESM (debt mutualization).  Ireland was recognized as an exception.  But these new terms will make it more difficult and will do little to tempt Spain's Rajoy from (finally) asking for formal assistance.  In fact, this has been the worst week for Spanish bonds since August, with the 10-year benchmark yield up almost 30 bp.  

The second development are reports suggesting that Greece is close to securing a package that would include being granted two additional years to bring its deficit to 3% of GDP.  However, time is money and where the extra 30 bln euros or so will come from is not clear.  Indeed, reports in the German press suggest a Bundestag majority may prove elusive.  Merkel has had to rely on the opposition SPD to pass key legislation to support the periphery, but as the campaign for next year's election gets under way, the SPD may be less willing and Merkel's CDU even less supportive of more assistance to Greece.  

Thirdly, S&P downgraded France's largest bank and revised its outlook for 10 other French banks to negative from stable.  This has not been sufficient to undermine French sovereign bonds, where the 10-year benchmark yield is off 3 bp, while the peripheral yields are higher.  However, we suspect this is the proverbial canary in the coal mine.  

We have argued that France shares more in common with southern Europe than northern Europe.  In this crisis, the key axis is between creditors and debtors.    The end of the credit cycle cannot be complete until all debtors are dealt with.  The adjustment comes first to small and vulnerable countries, Greece, Ireland and Portugal.  Spain is being addressed now.  Italy, to borrow a phrase from American baseball, is on deck.  France is in the hole.  Soon, perhaps after the elections next spring and after Spain is on a more formal program (next year it faces record issuance and arguably no LTRO to help), Italy will have its turn at bat.  Then France moves to the on-deck circle.  

Although a prisoners dilemma exercise would suggest Spain and Italy should ask for assistance at the same time, political considerations appear to be preventing such cooperation.  Therefore, we have suggested that when Spain does formally seek assistance, Italy will come under pressure.  Italy is the Maginot Line, to change metaphors, protecting France.  As Italy comes under pressure, France is likely to become decoupled more from Germany.  

 Stay tuned.