March Began like a Lion, Ends like a Lamb

The holiday casts a calm over the capital markets, here at month, quarter and, for some, fiscal year end. The dollar is little changed in the foreign exchange market and more of the same is expected in North America today. 

Asian equity markets were mixed, though the MSCI Asia-Pacific Index eked out a minor gain.  Although it sounds frightening, the threats by North Korea has not sparked much of a reaction among investors and the South Korean equity market rose almost 0.6%, making it one of the better performing Asian equity markets this week. 

The main economic news came from Japan. It reported a larger than expected fall in prices and an unexpected decline in industrial output. The country's CPI fell 0.7% from a year ago, compared with a 0.3% decline in January. Other measures, which strip out fresh food and food and energy also showed an increase in the pace of deflation. 

Tokyo reports CPI with a smaller lag, and in this city that has a governor instead of a mayor, saw March deflation increase to -1.0% from -0.9%. Core measures ticked up but still show little sign that the deflation's grip has really lessened despite a 13.7% decline in the yen since the election was announced in mid-November 2012. 

Separately, Japan reported a 0.1% decline in February industrial output. The Bloomberg consensus called for a 2.5% increase. That means the year-over-year contraction deepened sharply to -11.0% from -5.8%. The auto sector was particularly weak, with a 15.1% contraction from a year ago compared with a 9.9% decline in January. Japanese businesses have a subdued outlook and expect a 1% rebound in output in March and then a more modest increase of 0.7% in April.

Note that Japan's quarterly Tankan survey will be reported early Monday in Tokyo. A modest improvement is expected in the headline indices and in the outlook, but close attention will be paid to capex plans, which are likely to slow from the last survey. The BOJ meets next week and there are nearly universal expectations for open-ended purchases of longer term JGBs.

Perhaps related to disappointing Japanese output data, South Korea also reported an unexpected decline in industrial production. The 0.8% fall contrasts with forecasts of a 0.3% increase. This saw the year-over-year pace to -9.3% from a revised 7.6%. The lunar new year and number of working days may have distorted the data. Nevertheless, the government is obviously concerned and just yesterday announced plans for fiscal stimulus as it cut this year's growth forecast to 2.3% from 3.0%.

Many European markets will not re-open until April 2. When every thing was said and done, the euro was down about 0.5% for the month coming into this week. It lost about 1.3% as the anxiety over Cypriot developments and Italy's political uncertainty took a toll. The capital controls Cyprus needed to institute to minimize a disorderly response understandably sits uneasily for many.

Yet we are reluctant to accept the proposition that Cyprus has effectively left the monetary union or that they have in effect introduced a Cypriot euro. Intentions here matter, at least for the time being. When the former governor of the largest state in the US issued IOUs to cover some government expenses, no one claimed California was leaving the union or breaking the federal monopoly of the power of coinage.

We think that the situation will be clearer, even if it takes a few weeks to lift the capital controls. Many references to the fact that capital controls are still in place in Iceland seem to confuse analogy with argument. While it is possible that capital controls stay in Cyprus much longer, it does  not seem to be the most likely scenario. Cyprus has something that will be pushing it toward an timely exit from the controls that Iceland did not, namely the EU and ECB.

The market is casting about looking for the "next Cyprus". The consensus appears to be settling on Slovenia, where a new government is wrestling with a weak and leveraged (not nearly as much as Cyprus) banking system. Bond yields have risen sharply in recent days and the 5-year CDS has risen from around 240 to almost 355 over the past two weeks.