Two Key Drivers Lift Dollar, Pressure Yen

The break of the JPY100 has unleashed the animal spirits. The US dollar is broadly higher and equity markets are finishing the week on a strong note. Bond yields are mostly higher, led by a sharp 9 bp rise in 10-year JGB yields. Indeed, at almost 69 bp, the benchmark 10-year yield is the highest since late February.

There are two fundamental themes. The first is that despite signs of slower US growth here in Q2, the US labor market continues to improve. Weekly initial jobless claims and the smoothed 4-week moving average fell to new cyclical lows. There are several influences on the Us stock market, we find that the weekly jobless claims is among the most important high frequency economic reports that tracks the US S&P 500 very closely. This encouraged more talk that the Fed may taper off its purchases of long-term assets sooner than the market currently anticipates, which is late this year.

The second is the news reported in Tokyo, after the JPY100 level broke in North American yesterday, that Japanese investors turned buyers of foreign bonds. This is an important signal for the yen bears. They have been selling yen partly in expectation that that is what Japanese investors will do as they are displaced from the local bond market by the BOJ's qualitative and quantitative easing. However, this has not materialized until now.

The MOF reported that Japanese investors bought a total of JPY514 bln of foreign bonds in the two weeks that ended May 3. This seemed to some as confirming the talk of good Japanese participation in the US bond auction this week, including yesterday's 30-year sale. That said, the fact last week was thinned by the Golden Week holiday's we suspect the MOF data is more suggestive than indicative of the initiation of FY13 investment allocation decisions. 

The roughly $5 bln of foreign bond buying over two weeks is small beer in itself, yet a taste of what may be coming. Yet even that assumes that the backing up of JGB yields, and that fact that the bond markets that can absorb Japanese savings in size, i.e., core G7 bonds, are near record low yields and whose credit quality is questionable (many on credit watch).

The Financial Times tells us on the front page that the "yen's move through 100 to the dollar sets the stage for export boon". Though it does not quote anyone saying that, it is the inherited wisdom. Earlier today, Japan reports its March current account figures and the reason the largest surplus is a year was reported did have something to do with a weaker yen, but it was not in the trade account, which remained in deficit. 

 It was not about the goods market, but the capital market. Despite the lower foreign yields, the depreciation of the yen, boosts the yen-value of the foreign investment flows. The investment income surplus swell to JPY1.71 trillion from JPY1.41 in Feb and JPY1.50 in March 2012.

We would go further, as many observers do when it comes to bank lending, the supply side factors are emphasized over demand. The reason that Japanese exports to Europe have been falling is not so much about price of Japanese goods, but the fact that the economy is contracting. Moreover, for nearly 15 years now, the MOF data shows Japanese companies service foreign demand more by local production and less by exports. 

Those Japanese-brand cars driven in Europe and the US are largely made locally, not exported from Japan. Finally, we would note that the price of money changes much faster than the price of goods for various good economic reasons. What this means is that one ought not to expect the 14.4% decline in the yen this year to translate into a 14% decline for the price of Japanese goods.

Meanwhile, other macro developments have been overshadowed by the heightened talk of Fed tapering and speculation that Japanese savings are about to be exported. There were other developments seem noteworthy. First, following up this week's meeting, the RBA has lowered its inflation outlook and restated that its expects the economy to grow below trend this year. 

This shows the there is scope to cut rates further, though we suspect June is too soon. While several banks have passed on the full 25 bp rate to their mortgage rates, one large bank reportedly passed on 27 bp rather than 25. While this seems to have helped weigh on the Australian dollar (approached the $1.00 level, it seems like a little bit of catch-up after not having fully passed on earlier cuts.

Second, the UK reported a GBP9.1 bln March merchandise trade deficit. It was largely in line with expectations. There was improvement in the non-EU trade deficit. It fell to GBP3.5 bln from GBP4.2 bln. Export volumes picked up 5%, after falling 1.4% in Feb. Import volumes rose 3.6% after a 0.4% gain in Feb. Sterling was turned back again from the $1.56 area and has now been pushed below $1.54. Sterling is trading below its 20-day moving average for the first time in a couple of weeks. A close below it (~$1.5410), would add to the souring technical tone and signal a test on the $1.5200 area.

Third, Italy reported a horrific industrial production report. The 0.8% decline was four times greater than the consensus expected. The intractable political problem has been addressed, at least for the near-to-medium term, but the economic problem remains as powerful as ever. The EC expects the Italian economy to contract 1.3% this year. The OECD says 1.5% and Fitch says 1.8%. We are concerned that even Fitch is erring on the side of optimism.