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Next Wave of Global Upheaval Hinges on the Yen

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Monday, 13 Sep 2010 02:09 PM Current | Bio | Archive

While most investors are still wondering what Basel III will really mean, it now seems clear that the raising of bank-capital requirements will have the effect of raising the global cost of capital and thus slowing the trend global growth.

Believe me; this will matter as the world is facing a global war for capital.
In this context, I really don’t know if U.S. Treasury Secretary Timothy Geithner is doing what’s best for American interests by sounding touchy, at least for now, about China and their lack of action on foreign exchange.

I think he misses the point. Everybody must admit the United States hasn’t yet reached Third World status, so, at least in my opinion, the United States shouldn’t aim to compete on price with a Third World manufacturer.

That said, during the weekend, we also learned that Greece gets more money from the IMF. But, interestingly at the same time, the eurozone got a warning of sorts from former Fed Chairman Paul Volcker, who sees the stability of the EU project in “some jeopardy,” though this is, of course, in the context of the need for further efforts to reform.

Therefore, it’s certainly not an overstatement to say the Irish banking crisis is only the tip of an iceberg.

We shouldn’t forget that the Irish banking crisis resulted from the failure to resolve the banking crisis in the first place. Investors shouldn’t overlook the fact that Ireland and Germany are two countries with fundamentally weak banking sectors that are now left in some limbo, undercapitalized, yet not officially bankrupt. A solution for Ireland would consist in nationalization. For Germany, a solution is a massive consolidation of their “Landesbanken” and local savings banks.

Unfortunately, governments aren’t pushing this. Basel III’s implementation period is too long to force the change in the foreseeable future. So, watch out for the “so-called” surprises.

During the weekend, the German government’s incompetent handling of the banking crisis was once again illustrated when it emerged that Hypo Real Estate needs another 40 billion euros (US$51 billion) in state guarantees.

Surprise, surprise … the political reaction in Berlin was one of shock while the bank wants to create a bad bank, but there are huge risks associated with this endeavor because many of the banks’ assets are denominated in foreign currency, and other risky categories. Mr. Volcker has it right, once again.

Besides all that, the OECD released its July 2010 composite leading indicators (CLIs), which attempt to indicate turning points in economic activity approximately six months in advance, which point to clearer signs of a moderation in the pace of expansion compared to last month’s assessment. The CLI for the OECD area decreased by 0.1 point in July 2010.

It states that in Canada, France, Italy, the United Kingdom, China and India there are stronger signals of a slower pace of economic growth in coming months than was anticipated in last month’s release. Stronger signals that the expansion may lose momentum have emerged in Japan, the United States and Brazil. Tentative signals have also emerged that the expansion phases of Germany and Russia may soon peak.

The OECD Development Centre’s Asian Business Cycle Indicators (ABCIs) show that the recovery of ASEAN economies keeps on track with some signs of moderation.

Meanwhile, the Economic and Financial Affairs directorate of the European Commission said the eurozone’s GDP will grow at 1.7 percent in 2010, up from the 0.9 percent forecast in May but warned of “a moderation of growth” in the second half of the year, of 2 percent annualized in the third quarter and 1.2 percent in the fourth quarter, down from 4.1 percent in the three months to the end of June.

So, where do we stand now on risk-aversion: off or on?

I see a resumption of many of the trends from the first half of the year.

The question that needs to be asked now is what could upset the current uneasy balance in the major currency pairs to allow this to happen.

Yes, that’s right; the real upheaval in all the markets will probably be triggered in the currency markets. From my side, I think that the most likely cause would be a sudden surge in the value of the Japanese yen.
I see three possible causes for this.

First: In Japan, the leadership election on Tuesday, Sept. 14, presents a roughly even standing of the two runners in the race as a result of the weighted voting system used. A victory by Ichiro Ozawa in the race to be Japan's prime minister could be the cause of considerable market volatility given the aggressive initiatives he is proposing to turn the economy around.

Nevertheless, the fact that both candidates in the race have spoken about being ready to intervene in the currency markets indicates that this is unlikely to be the decisive factor, although the removal of political uncertainty should prove a modest yen positive in itself.

Second: Besides that there is a second possible cause for a surge in demand for the Japanese yen could simply be the need for Japanese companies to repatriate funds home ahead of the fiscal half year end. However, I suspect that rather than being a primary force, this simply will help add to the weight of the flows some evidently already moving into the Japanese yen, driven by the evident problems facing many other major currencies. Instead, it seems to me that the most likely reason for a sudden surge in the value of the Japanese yen is the buildup in international tensions over the possibility of intervention by the Japanese Ministry of Finance (MOF.)

Third: Given the events of the past decade and the clearly defined stance of the past two U.S. administrations on this issue, Japan certainly expects to have to carry out its intervention campaign on its own. As this is clearly a higher risk strategy than multilateral intervention, the authorities must therefore hope for as much tacit support as possible from their G-7 partners.

Although open verbal support from the U.S. and others is almost as unlikely as multilateral intervention, Japan must look for them do the next best thing and simply “say nothing.”

Indeed, this was exactly the point Prime Minister Naoto Kan was attempting to make last week. On Friday he stated: “We could say the eurozone is almost trying to guide the euro to weaken, while the United States wants to double its exports as President Obama has said. So it is difficult to get them to cooperate in a joint intervention. But we have been urging other countries not to react negatively if Japan decides to take some sort of action.”

Unfortunately, the early signs are that Prime Minister Kan may not get his wish. Speaking on Bloomberg TV late last week Treasury Secretary Timothy Geithner stated, when asked whether he would back Japanese currency intervention: “My view is that they should be focusing, like we are, on how to make sure they are reinforcing recovery in Japan, doing things to help make economic growth in Japan stronger. That would be good for us, good for Japan’s trading partners.”

With currency tensions in the region becoming increasingly fractious anyway both between China and Japan and the U.S. and China, the very real risk is that intervention by Japan ends up inviting open criticism from the U.S. and even China. Such official criticism would almost certainly doom the intervention to failure.

For investors, it’s important to take notice of this situation because such a turn of events would almost inevitably feed through into a swift strengthening of the Japanese yen and consequently a new fresh round of weakness in Japanese equities.

Were this to feed through into more general risk aversion, which in my opinion seems a reasonable possibility, then this could also prove the decisive factor in taking EUR/USD out of the corrective pattern it has been stuck in since the start of June.

“Risk aversion on” is dollar up and most of the rest in the markets down. “Risk aversion off” is euro up and most of the rest in the markets also up.

As always, we’ll have to wait and see what happens.

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HansParisis
While most investors are still wondering what Basel III will really mean, it now seems clear that the raising of bank-capital requirements will have the effect of raising the global cost of capital and thus slowing the trend global growth. Believe me; this will matter as...
hans,parisis,yen,currency
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2010-09-13
Monday, 13 Sep 2010 02:09 PM
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