Unity of Opposites Makes Markets Nervous

There is a nervous calm in the foreign exchange market, where yen strength, on what many are dismissing as fiscal year end adjustments, is the main exception.  The focus remains in Europe and the main talking point is about the Cypriot capital controls.  Many observers, including some banks, are emphasizing the obvious contradiction between capital controls and the currency union.   

Yet, we do not think the die has been cast yet-- and do not see the capital controls as necessarily tearing the euro zone asunder or a prelude to a Cypriot exit.   Nobel prize winning economist Paul Krugman has called for Cyprus to leave, but we are not convinced, and more importantly, the Cypriot people, according to polls, are not convinced that exiting would be better.

  

The Cypriot crisis is not a traditional balance of payments problem that can be resolved by currency devaluation, though unit-labor costs have risen.  It does not have the manufacturing capacity to increase exports to fund its debt servicing.  It claim on the oil and gas fields is difficult, if not impossible, to enforce given the island's division and the unresolved dispute with Turkey.  

 The combination of the heightened tensions due to Cyprus and the policy response and the unresolved Italian political situation has widened the iron jaw in Europe as German bund yields fall--with the 10-year recording its lowest yield since early last August--and Italian yields approaching their highest level since the state of the month, up more than 30 bp this week.   

The widening premium through out the periphery may be an issue for the ECB as Draghi has interpreted this in the past to be a breakdown of the transmission mechanism of monetary policy.  We have argued that breakdown is with the recycling mechanism by which creditors' surpluses were used to finance the deficit countries.  That said, though there are some predicting an ECB rate cut next week, we expect the door will be left open, but that the ECB will not panicked into a move.  

We suspect a move is more likely later in Q2.  Current weakness of the euro area economy is not unexpected so the bar for a rate cut is high.  However, if, as we expected, the weakness is more prolonged, then that could lead to a cut.  In addition, it might not be growth per se, but the risks of deflation that may be used to justify a cut. German and French inflation is low and falling.  Measured inflation in several other countries has been inflated by administered price and tax increases.  Money supply, with Feb figures reported today, continues to tend lower after peaking last Oct and lending to loans to businesses and households fell for the tenth consecutive month. 

Separately, Germany and Japan reported better than expected retail sales figures.  The 1.6% year-over-year rise in Feb retail sales in Japan was three times more than the consensus forecast.  However, the fact that the Jan series was revised to -0.2% from +2.3% preliminary reading means that the Feb data has to be taken with some degree of skepticism.  

German retail sales rose 0.4% in Feb on top of 3% in Jan.  The market had expected a 1% decline.  Here, however, the surprise is in the year-over-year rate, which slumped to -2.2% form +2.5%, for which the consensus had forecast a 1.2% increase. 

Fiscal year end adjustments may be distorting the weekly MOF data as Japanese investors continue to repatriate funds.  Between stocks and bonds, Japanese investors sold JPY1.13 trillion in the past week. Perhaps more interesting is the shift in foreign activity.  For the first time in 19 weeks, foreign investors sold Japanese shares and for the third consecutive week sold Japanese bonds.   

Lastly, we note that Chinese shares were sold, led by the financial shares with the Shanghai Composite falling the most in three weeks and surrendering this year's modest gains.  The trigger appears to be a combination of regulation and deregulation.  Officials want to tighten the rules on wealth management products, but ease some of the regulation on interest rates.  One Chinese bank estimated the impact of the new wealth management rules is tantamount to draining CNY1 trillion from the economy. 

For its part the dollar has been trading an exceptionally narrow ranges between CNY6.2080 and CNY6.22 in the spot market since early this month and made a new marginal multi-year low yesterday.   Today the dollar briefly traded above its 20-day moving average for the first time since the end of February.