Less Sure

Though Abe rejects
Calls for his resignation
Traders are less sure

Amidst another dull FX session, where the dollar is overall little changed, the drumbeat of scandal continues to get louder in Tokyo. Pressure is clearly increasing on FinMin Taro Aso to resign over the scandal where he is alleged to have altered documents involving a sweetheart real estate deal for one of the PM’s friends. And while Aso has been in the cross hairs for the past week, yesterday, the PM’s own party legislators were demanding answers from Abe himself! This matters because there is a small but growing belief that Abe may be forced to step down over the scandal, and in so doing, take the reflationist mindset with him. The upshot is there is a growing risk of a more significant strengthening of the yen. Having already appreciated more than 6% this year (including 0.35% overnight), the yen is the strongest performer in the G10. And this is with an administration and central bank that are consciously trying to undermine the currency. If there is a forced change at the top, and the new PM and administration is evenly modestly less forceful in their views regarding the ongoing efforts to address what has become a national mindset on deflation, the yen will have much further to rally.

As an aside, there was another interesting tidbit out of Japan this week; one that I think bodes ill for the ongoing efforts to weaken the yen. On Tuesday, there were exactly zero trades of the key 10-year JGB in the Tokyo market. None, nada, zip! This is unprecedented. Never before has the bond market in a major economy actually seen no volume during a session. Ultimately, the BOJ’s QQE program has succeeded in completely undermining the value of the marketplace in JGB’s. Remember, a market is designed to give price signals to both buyers and sellers, but if it doesn’t trade, no signals are forthcoming. So what is the proper price of 10-year money in Japan? The answer is that since the BOJ started its yield curve control program, there is no way to know. I guess you could say they are doing a good job of controlling the rate as it is whatever they say it is. But that is not a healthy situation for the world’s third largest economy. And of course, how can they continue to pump money into the economy if nobody is willing to sell them the bonds?

My point is that there are significant troubles in Japan and therefore a growing potential for an outsized market impact, especially on the yen. Don’t be surprised if you hear in the next months that the BOJ is buying US Treasuries or even US equities as part of their reflationary efforts. Both of those would serve to weaken the yen as the BOJ explicitly buys dollars for the purchases. In the back of my mind, I also see a growing probability of actual debt monetization in Japan, where the BOJ ultimately tears up JGB’s when they mature and leaves the money in the economy. That is an inherently inflationary action, but one which will be extremely difficult to control. However, given the decades of failure surrounding Japanese efforts to halt deflation as well as the diminishing toolkit available to the BOJ, don’t be shocked if something like this happens.

In the meantime, all signs point to further yen strength. The combination of events and market circumstances seems to be overwhelming any current reflationary strategy. And that is before a situation where Abe is forced out. If he goes, then things happen much faster. In fact, it could trigger a more widespread market disruption, negatively impacting equity markets everywhere and driving investors to perceived safe havens, ironically including the yen. I am not saying this is the future, merely that it is not a zero probability event.

And with that joyousness out of the way, let’s look at the rest of the market. Overall, the dollar is a touch stronger today, although it remains mired in its recent trading range with no sharp movements anywhere. It is becoming increasingly clear that traders are looking to next week’s FOMC for the next big clues. Yesterday’s data proved disappointing with regard to Retail Sales, as despite a seemingly robust economy, sales actually fell. PPI demonstrated price pressures are slowly building, but overall it is hard to believe the data would have changed any views at the Fed. This morning brings some more information including Initial Claims (exp 226K), Empire Manufacturing (15.2) and Philly Fed (23.0). However, it is difficult to see how these will be significant enough to drive markets.

After a down day yesterday, equity futures are pointing slightly higher in the US which is in synch with the price action seen in Asia and Europe, modest gains. Absent another key political surprise, it is hard to see a compelling reason for the dollar to move too far in either direction ahead of the FOMC next week. As such, while I do believe the pressure for the yen to strengthen will keep up, I don’t see much activity elsewhere.

Good luck