Yen at lowest level against USD since last July

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The US dollar is continues its broad rally as doubts over Greece persist, although currencies continue to trade in relatively tight ranges.  Overall, G10 currencies are mostly weaker against the dollar with the Japanese yen down 0.6%, currently trading at 80.31.  Sterling is trailing gains in the yen, down 0.5% against the dollar, after the BoE minutes revealed a more dovish voting arrangement than expected with two members voting for a £75bln expansion of QE. The euro continues to slide for the second day, down 0.1% to 1.322 but is likely to remain confined to its recent range of 1.298 -1.330.  Near-term support seen at 1.313 with resistance seen at the upper end of the recent range.  The Australian dollar is trading lower to 1.063 despite a rebound in the conference board and Wespac leading indicators in December.  Global equities are mixed with the MSCI Asia Pacific index up 0.09%, while the EuroStoxx 600 is down 0.8%. 

While European drama continues to command attention, the yen has quietly depreciated and is now at its lowest level against the US dollar since last July and is at four month lows against the euro.  There are several factors that appear at work.  The unexpected increase in the BOJ’s asset purchases (QE) announced on Feb 14 helped accelerate the yen’s slide that had already begun.  We suggested that BOJ intervention should be considered not when the yen is strengthening, but instead intervene when the yen was already falling and officials would have the wind at their back.  In some ways the QE did precisely that.  We have noted that thus far this year, foreigners had been buying few Japanese assets, while Japanese investors had stepped up their purchases of foreign assets.  There are three key relationships for investors with yen exposure presently.  First, as the BOJ governor noted last year, the dollar-yen rate is correlated with 2-year interest rate differentials.  The differential was widening since the start of the month and extended by the BOJ’s QE decision.   The 60-day correlation conducted on the level of the yen and the level of the rate differential now stands at -0.79.  Second, is the relationship between the yen and oil.  The key takeaway here is that while the relationship is important, this still pales in comparison to the 2-year interest rate differential.  Third and finally is the relationship between the yen and the Nikkei, which a correlation of the level indicates that yen weakness is associated with Nikkei strength.  Altogether, the correlation between the 2-year interest rate differential and the Nikkei has become positively correlated with changes in the yen.  That means, widening interest rate differentials weighs on the yen and underpins the Nikkei, where fund manager appear underweight.         

On the data front, euro zone PMIs for February surprised on the downside, with the composite PMI output slipping below 50 (to 49.7) after a slight expansion in January (at 50.4).  The extreme cold spell in February may have dented sentiment to some degree as it kept consumers at home and halted construction projects.  On the other hand, the worse-than-expected headline numbers in both sectors may reflect some payback from the improvement in January when the mild weather may have distorted the figures.  In any event, it remains to be seen if this is a temporary setback or the start of a renewed downtrend.  The data highlights that the euro zone is not out of the woods yet.  In fact, growth disparities are getting more pronounced between as a result of the debt crisis, which is forcing governments to implement stark austerity measures.  As we have argued before, the headwinds from the fiscal tightening and the sovereign debt crisis will likely provide setbacks to a smooth economic recovery.  Looking ahead, we still believe the ECB will remain on hold at the March 8 meeting.  In particular, the governing council may be questioning the benefits of another rate cut amid the improvement in financial market sentiment as Draghi appeared to signal a high bar to rate cut at the February 9 press conference. 

As we have argued, China policy makers are stepping up to try to stem the growing downside economic risks. Overnight we had modestly supportive news relating to the bank lending and real-estate, as well as an improvement in the unofficial Feb. manufacturing PMI from 48.8 to 49.7. The Shanghai government has reintroduced a rule allowing people with at least three years of official residency to buy a second home. We take this as a sign that action is moving ahead of official rhetoric, which has continued to be on the restrictive side. We expect more positive news for the housing sector, but think the government has fallen well behind the curve in this area. Separately, the local media suggest that China’s four big banks are increasing lending towards the end of February, even though lending is still falling well short of expectations. Even though we share many observers’ concerns about the health of the banking system, we remain optimistic that lending will accelerate, probably after the PBoC’s 50bp RRR cut takes effect this Friday. If we see no evidence of higher lending by mid March (when the official lending February data is released) we will probably be forced to revise our view in this area. Despite the growing risks we maintain our base case of a soft landing and for more policy stimulus than the markets are pricing in.