Japan: Yen upside risk on deflation threat

By Marc Chandler

Today is first time in two weeks that the US dollar has been above JPY77 and thus far the penetration is minor. Although no doubt Japanese officials and corporate Japan would prefer a weaker yen, given the concerns about the impact of the success of the SNB in blocking hot flow entering Switzerland, the stability of the yen must be partly welcome.

Even if one does not monitor developments in the options market, the fact that the gap between the volatility of the euro (3-month) and yen is now at the highest level since late 2008/early 2009 illustrates the extent of the euro debt crisis and the reluctance of the market to risk BOJ intervention. The steepness of the yen vol curve (1 month to 1 year) suggests the low vol environment is not expected to last. An increase is vol seems more likely on a break of JPY76 than a return to say JPY78.

Speculative net yen longs at the IMM have held between 32.5k-58.8k since mid-July. Given the convergence of US and Japanese rates, the cost of holding long positions (negative carry) is practically nothing.

In terms of flows, the MOF weekly data reported today showed foreigners liquidated some of their bill holdings. We have suspected that a good part of the bill demand by foreign investors (~JPY5.5 trillion in Aug) was a way to speculate on the yen within mandates that often deny asset managers the ability to have naked currency exposure. Given the IMM positioning and the "normal" noise in the weekly time series, it is too early to think that a single week of bill sales in late Sept is a convincing sign that players are giving up on the eventual break of JPY76.

Equally important, the weekly MOF data indicates that Japanese investors stepped up their acquisition of foreign financial assets in September. In fact the weekly time series suggests Japanese investors bought about JPY2.73 trillion of foreign bonds, stocks and money market instruments in September, the most during this calendar year. This is noteworthy also because in September, the end of the Japanese fiscal half year, many expect repatriation not new purchases, and surely not such strong outflows.

More broadly, the recovery from the March tragedy appears to be running out of steam. Retail sales which surged in the April-June period fell in both July and August and deflation appears to be threatening again. The year-over-year pace of national CPI is expected to slip back to 0.1% in August, when reported in early Tokyo on Friday. The Sept readings for Tokyo are expected to be -0.2% year-over-year.

Japan also will report August industrial production figures as well. A pick up after a disappointing 0.4% rise in July is expected, but it is unlikely to impress as household spending will remain depressed (consensus is for a 2.8% year-over-year decline in August after a -2.1% in July and the much worse than expected Aug retail sales (-1.7% vs consensus +0.2%). The industrial output is not going into domestic consumption. It could be geared for exports or destined for inventory.

Early Monday in Japan the Q3 Tankan will be reported. While positive readings are expected for the large manufacturing and non-manufacturing, the forward looking outlook for Q4 is not expected to show much improvement, suggesting the economic headwinds are still anticipated.

In recent weeks, Japanese policy makers appear to have been focusing on other measures outside of intervention to deal with the yen’s strength. The more that there is talk of other action, the less intervention may be feared. There are reports in the local press that a large Japanese bank is considering buying US dollar assets from European banks. There has been other reports suggesting that there may be some official Japanese flows or support for European bonds. This does not appear to be short-term solution for Europe or the yen. Some have suggested that Japan may launch a sovereign wealth fund, as many other Asian countries and large reserve holders already do. Very early on in the Greek crisis, we noted that Japan offers to insure through the Japanese Bank of International Cooperation, emerging market samurais. Maybe its time has come.

We suspect that what minor yen weakness is being seen now is temporary in nature and the bigger risk remains on the yen’s upside.