Euro Rises despite Official Failures, Yen Consolidates

One would not know it by looking at the euro sitting at its best level in three weeks that European officials have failed to reach not one, but two agreements this week--to secure Greek funding and to agree on a new 7-year budget for the EU.  

Of course some observers are playing up the stronger than expected German IFO and the better French business confidence, but to do so, one needs to forget that yesterday's flash PMIs remained sufficiently weak to signal to the Markit economists that the German economy is contracting this quarter by 0.3%, completely wiping out the Q3 gain of 0.2, while the French economy may contract 0.7%.

  

To be sure, both a Greek deal and a EU budget will eventually be worked out, with tortured results.  Consider that the talk of a bond-buy back to reduce debt (in private sector hands) has sparked a rally in Greek government bond to the highs since the restructuring.   And even the other elements, including a transfer of ECB profits on Greek bonds (distributed through national central banks) and lowering interest rates on existing official lending, the debt is still projected to be higher than 120% in 2020.  

The IMF reportedly is compromising and will agree that 124% debt/GDP is sustainable.   As we have noted before, the IMF's ability to forecast Greece's GDP means that these very precise numbers are anything but; that these numbers are largely arbitrary.  These is a macabre dance taking place under which officials must make it appear that credible that they will be paid back.  In fact, this is why Germany's Schaeuble argued official debt forgiveness must be ruled out because that would rip that veneer off.  

Although talks are continuing, reports suggest that the EU is highly unlikely to reach a budget deal today.   A third of the EU's budget is earmarked for agricultural subsidies that the recipients, led by France  (~9.5 bln euros in 2014) are loath to give up.  About half the budget is for infrastructure spending and here too the biggest recipients do not want the largess cut.  The UK's negotiating position seems to be advocate cuts in everything but its rebate and that it wants increased.  Denmark likes the UK rebate so much it wants one just like it.  You get the picture. 

The dollar reached a high near JPY82.85 yesterday and is consolidating today.  There is market talk of strong (~$1-$2 bln in dollar offers ahead of the JPY83 barrier).  It has, however, held above JPY82, now for the second consecutive session.  In the four days this week before today, the yen has lost about 1.4% against the dollar and 2.5% against the euro and almost 2% against the Australian dollar. 

The key driver of the yen's decline is that the LDP, under Abe's leadership, is expected to head up the next government.  He has been staking out aggressive position in terms of monetary policy and ensuring the BOJ will do the government's bidding.  However, in an interview today he is playing the use of fiscal policy levers.  He has suggested a JPY200 trillion public works program, which may be financed by new debt.  He is also suggesting waiving the implementation of the retail sales tax (2014), for which there is an opt-out clause relating to the strength of the economy.  

On the other hand, Abe has indicated he is likely to be less interventionist that the DPJ.  Recall that Oct 31, 2011, the MOF authorized massive BOJ intervention, estimated at nearly $100 bln.  Of course, there may be less need for intervention given the Abe's other policies.  

Taken together, it does suggest Abe is willing to face the wrath of the rating agencies.   That said, 10-year JGB yields are up a single basis point this week to 0.73%.  They are among the best performing bonds this week, outside of Italy and Spain.  The Nikkei too is among the best performers this week with a 6% gain.  A local paper reports of strong call demand the Japanese stock market coming from macro hedge funds and retail accounts.