Turning Japanese - Derivative Logic

Last Week: Overall a quiet one, the highlights of which were a meeting of current and old Fed Chiefs and the release of FOMC minutes that reinforced our view that officials will hold off tightening again until at least June. A corollary however, is that more tightening is likely and more than the market is currently anticipating. The 10-year Treasury traded lower by 4.9 bps to 1.72% while 1-month LIBOR also traded lower by 5 bps to .4347%.

This Week: A lively week ahead for US data and Federal Reserve speakers, with retail sales and data on consumer prices taking center stage. The data isn’t expected to change our view that America’s economy continues to grow at a slow but steady pace. Corporate earnings season has begun and economists will attempt to rationalize what’s expected to be a weak read on corporate profits. The question is, what’s causing it, the double whammy of weak commodity prices and a strong dollar or just slower growth? Do weak earnings portend a recession?

Take Away: The recent global anxiety about US interest rates has waned – the latest Fed guidance is being read broadly as dovish for the moment and has provided relief to markets everywhere.

However, focus remains very much trained on the global backdrop both for its direct impact on market sentiment and for its importance in the Fed’s thinking. Lately, there’s been a chorus of Fed speakers mentioning the significance of the global economy and the potential for downside global risks as a reason to delay the next Fed hike.

Focus on the economic state of the world isn’t anything new though, as interest rate traders have been forced to be oil traders over the recent months due to black gold’s influence on Fed-think and interest rates. Now, Rates traders are forced to be currency traders as well, as a sudden strengthening of the Japanese yen recently caught the world’s attention as the next possible shoe to drop.

Why should the Fed care about Japan and it’s currency you ask? Here’s a primer:

As you may recall us saying before, Japan is doomed. It’s population, and hence it’s economy, is shrinking. The pace of Japanese bank lending is barely growing at 2% despite massive asset purchases by it’s central bank, the Bank of Japan. Business investment spending is down a third since the 1990’s. Residential construction has plummeted – who needs new houses when the population is shrinking? As a result, Japanese commercial banks are investing offshore as fast as they can in an effort to make up for the lack of return/activity in the home country. Normally, this would weaken the Yen, as these banks sell it for other foreign currencies as part of their offshore investment activity. However…
The Yen is strengthening, not weakening, so much so that it’s made financial headlines since February and accelerated in recent days sparking the market’s attention anew. A strengthening yen is the exact opposite of what the Bank of Japan and Japanese commercial banks want, and the Japanese government has spent trillions pulling economic levers trying to turn it’s economy around, one of which is to weaken the yen to aid exports of Sony TVs and Lexus sedans.
How can this be happening? What we’re seeing is a huge short-covering rally of the Yen as hedge funds repay Yen-denominated, “carry trade” loans, an action that’s being driven by the availability of even cheaper European sources of financing. The classic “carry trade” involves borrowing in a low interest rate currency (traditionally the Yen) and reinvesting the yen proceeds into a currency with a higher interest rate and pocketing the difference. The problem for Japan is that, due to the recent fall in global treasury yields, European financing is looking cheap, prompting the hedgefund driven un-wind.
Does the Fed care about Japan? Why yes it does. Japan is the third largest economy in the world – behind the US and China – and is one of the largest foreign purchasers/holders of US Treasuries. Japan plays a central role in the “global economic” part of the Fed’s “global economic developments” statements of late.

Japanese data set for release this week should confirm it’s sad state: look for data on Industrial Production, GDP, retail sales and exports to confirm that the Japanese economy shrank in Q1. If so, the Fed will have yet another reason to push back any planned hike in US interest rates.

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