I have had a bit of a catch-up with the currency markets. I was feeling out of touch with currencies in particular — I found that I could not tell a compelling story about what was going on for anything other than JPY and AUD. It seems there is a reason for this. Taking out the gyrations of JPY, other currencies have mostly been range-bound. I look at currencies in three ways: as a simple average of the currency against four or five other major currencies; as a trade-weighted average; and against various other currencies individually. USD looks fairly strong on a trade-weighted basis and is towards the top of a range it has occupied since early Autumn on an average basis. However, excluding JPY from the simple average, USD is in the mid-to-low end of its post-August range. EUR remains on a broad down trend but managed a bounce in January’s risk rally which it has not since given back, on both a trade-weighted and average-ex-JPY basis. GBP remains in the broad range that it has been in since the middle of the summer on an average basis, and since at least last Spring on the average ex JPY. On a trade-weighted basis, it is in the middle of a range that has existed since the summer. AUD has been strong on any measure, and on a trade-weighted and average basis it remains close to its post-crisis highs. The average ex JPY has been rolling over since mid-February but remains in the vicinity of its highs.
JPY has been the big stand-out of the past couple of months, having dropped sharply. There are three possible reasons for this: the decline in the current account, the BoJ’s latest asset purchase programme, and the BoJ’s new 1% inflation goal. It is tempting to think that the decline in the current account has led traders to turn to JPY as a funding currency (having less fear of persistent upward pressure on the currency), but I do not think that that is the main explanation, because Japanese equities have rallied strongly as the currency has fallen. I suppose it could be that the weaker currency has led investors to pile into Japanese exporters, but remember that we are trying to work out the underlying cause of all these moves. If a fall in the currency is expected to cause a resurgence in exports, then it will cause a resurgence in the current account, and thus place renewed upward pressure on the currency, and hence a fall in JPY and a rise in Japanese exporters’ equity on account of a falling current account should be self-limiting. The latest move has been sharp and very fast (while the current account has been deteriorating all year on rising energy imports as a result of the nuclear shutdown), which is suggestive of a sudden and clear change rather than an ambigous one.
That leaves us with the two other explanations: asset purchases and the BoJ’s new inflation goal. I don’t believe in the inflation goal — i.e. I don’t believe that the BoJ will now pull out all the stops to meet it. Mr. Shirakawa remains a sceptic both on inflation targeting and on the ability of the BoJ to meet a target without action from the fiscal authorities (which shows no sign of emerging from Japan’s chronically gridlocked political system). What is more, the market doesn’t believe in it either: 7-year breakeven inflation has been on an upward trend for some time and has continued to rise since the BoJ announcement, presumably on account of improving economic prospects, but the 3-year breakeven inflation has actually been falling since the BoJ announcement.
Thus there is only one explanation left: asset purchases. I have long argued that the effect on expectations is the most important thing when it comes to assessing whether central bank action at the zero bound will have a stimulative effect. With respect to the equity market, the BoJ’s action at least signals that politicians’ demands that it do something about inflation are getting through. A chink has appeared in the BoJ’s armour, and that ought to have a simulative effect. There will also be a real-money-flow effect (I am not sure how large this effect will be, but it will be positive). With respect to the currency, many investors, including outside Japan, have taken the BoJ’s action as a signal to use JPY as a funding currency (perhaps remembering the same thing during the 2000’s QE and ZIRP — although that would be the market displaying a remarkably long memory!) and again, at the margin, the asset purchases represent an incremental move away from the acceptance of deflation and thus of the continued appreciation of JPY. Thus, JPY should fall, and Japanese equities should rise, in tandem. That is what has happened.
I think I have been too slow to think this all through. My scepticism about the inflation goal led me astray. The asset purchases are big, and they ought to matter. How much further they will matter, after such sharp moves, is a moot point.
US 2-year rates moved higher on Friday, out of the top of their recent range. Why? The interest-rate futures did not show a similar increase, and indeed remain at low levels (a sign that the markets, if not economists, take the Fed’s 2014 language as a commitment rather than a speculation contingent on the state of the economy). 2-year breakeven inflation rose a little, but it has been on an upward trend for some time and has not seemed to have a large effect on 2-year nominal rates. Perhaps its effect has started to increase. Or perhaps, given the strong correlation of the 2-year interest-rate spread with USD/JPY, systematic funds have pushed up the US 2-year in an attempt to trade this relationship. But neither of these seems a very satisfactory explanation. Falling real yields (i.e. movements in TIPS) are the origin of the rising breakeven, and the direction of causation should run from the interest-rates spread to the currency, not the other way around. It seems to me that 2-year rates are in the wrong place, and too high.
China’s Trade Balance
China has posted the most negative balance on record — the biggest deficit by far since the country started to become a force in the global trading system in the early 2000’s. Slower-than-expected export growth was the cause: exports were up 18% YOY, while imports were up 40%. My first reaction is caution. China’s economic data are awful; the Spring Festival distorts everything; and this is a huge deficit, as big as the largest post-crisis monthly surplus. I do not know what it means and I don’t intend to take any bets that depend on it until I find out. Perhaps someone just put the decimal point in the wrong place…
- Japan household confidence 39.5 — not too bad.
- China trade balance -31.5bn d.e. Feb.
- Non-farm payrolls 227k b.e. Feb. Another relatively strong number.
- Trade deficit widened to the extreme of its post-crisis range, d.e. Jan. Presumably February’s rising oil price will mean an even larger deficit in Feb.
- Unemployment 8.3% a.e., flat, Feb.
- Federal budget balance (Mon).
- BoJ Rate (Tue).
- UK trade balance (Tue).
- FOMC meeting (Tue).
- UK employment data (Wed).
- Eurozone CPI and IP (Wed).
- Current account (Wed).
- Empire State and Philly Fed surveys (Thu).
- CPI (Fri).
- Capacity Utilisation (Fri).
- IP (Fri).
- Prelim. Michigan sentiment (Fri).