Yen Bulls Spooked

The dollar initially fell against the yen in the immediate knee-jerk reaction to S&P two-notch cut of Spain's sovereign rating. It dipped briefly below JPY78. However, it has rebounded smartly and is holding above yesterday's highs. There are four considerations today.

First, Japan reported a whopping 12.6% decline in total machinery orders in August, after a 2.6% decline in July. Core machinery orders, which serves as a better proxy for capital expenditures, fell 3.3% on the month, which was about a third larger than the consensus expected. Poor domestic and foreign demand saps the incentives to expand the capital stock. This reinforces economists' belief that the Japanese economy, like the euro zone economy, likely contracted in Q3 and the prospects for Q4 are also poor.

Second, and following from the weak economic outlook, the BOJ will come under increasing pressure to ease monetary policy more aggressively. Finance Minister Jojima and Economic Minister Maehara are being more vocal about this than is often the case.

While in the US, the Fed's leadership (the real Troika: Bernanke, Yellen and Dudley) is pulling the central bank toward great accommodation, at the BOJ, Shirakawa appears to be restraining more aggressive impulses. However, we anticipate that after the election (no date has been announced yet), the pressure on the will increase further under an LDP-led government.

Third, Japanese officials seem to have spun their informal discussion of the hardships being imposed by the yen's strength. They have highlighted the fact that the other G7 members did not object. However, other officials said they simply let it pass. Silence does not mean acquiescence, though that is essentially what Japanese officials want the markets to think.

Japanese officials argue they are being hit with a triple-whammy: yen strength, the euro area crisis and the slow down in China. While few can dispute that, Japan does not win a great deal of sympathy, as others feel they are being impacted by the same forces.

Last year's BOJ intervention was criticized by US and European officials. There is no reason to suspect a different response if the MOF orders unilateral intervention.

Traditionally, the best grounds for Japanese intervention is the G7 admonishment against excessive volatility. However, that claim, which Japanese officials have resurrected now, simply does not apply. The problem is not that the yen exchange rate is volatile. In fact, just yesterday the 3-month implied volatility recorded its lowest level in several years.

In any event, judging from the CFTC Commitment of Traders, speculators have been accumulating a long position since the beginning the fiscal year in early April. The gross long position has grown more than five-fold to over 50k contracts. The fact that the JPY78 area, the lower end of the recent range held and the threat of intervention was raised, some longs looked to have liquidated.

Fourth, also weighing on the yen is the general risk-on tone today and risk-reward given where the yen is relative to the recent range favors selling yen, not just against the greenback, but on the crosses as well.

We suspect that Japanese official comments were aimed just as much to their domestic audience as the international market. Jojima acknowledged that the US and Japan are "at odds" on foreign exchange policy, but indicated that it would intervene if necessary over the US objections. This plays well in a country where nationalistic voices are moving into ascendancy.

Yet when every thing is said and done, more will be said than done. The dollar looks to run into offers as it approaches JPY78.80-JPY79.00. Similarly the euro, which is also recording an outside day against the yen, is likely encounter resistance in the JPY102.00-JPY102.50 area.