Japan and monetary policy, German Elections, China and AUD weakness

In Japan we see increasing signs of officials moving closer towards our way of thinking in respect of reviving Japan’s money multiplier which is conditional for ‘Abenomics’ to succeed. This morning the BoJ’s Takako Masai suggested that ‘excessive’ falls in interest rates could undermine the economy, a view we advocated in January when the BoJ rushed into its negative interest rate policy. A too flat yield curve not only runs the risk of leading to an deflationary increase of real yields via inflation expectations falling at a faster pace compared to the potential nominal yield decline, a too flat yield curve also tends to undermine bank profitability. A non-profitable banking sector faces balance sheet pressures making it difficult to turn central bank liquidity into high powered liquidity within the economy. It has been Japan’s banking sector balance sheet retrenchment reducing the amount of effective JPY in the system causing the JPY to rally. It was Japan turning towards yield curve management combined with internationally steeper yield curves allowing yield differentials to turn against the JPY.

This morning it isn’t the release of weak Japanese trade data moving the market. The 10.3% October export decline undershoot expectations (at -8.5%). The 16.5% fall in imports allowed net trade to add 0.5% to GDP. The driver for JPY weakness is found in the JGB yield curve, where the 10y now trades at 0.025%, which is above the BoJ’s 0% target. The BoJ should soon enter the market buying long dated bonds to push yield levels back to desired levels. When the BoJ moved towards yield curve management in September it had two incentives. First, to establish moderate steepness in order to allow commercial banks to shift their short-maturity JGBs (16.5% of total assets)holdings into the back end of the curve. This operation is essential to avoid another unwanted decline of broad money supply growth. Secondly, to create conditions for yield differentials to widen in favour of currencies creating an incentive for private Japanese entities shifting capital abroad and thus weakening the JPY. Last week the BoJ moved towards quasi-unlimited QE prioritizing managing the JGB curve. The BoJ has created an efficient mechanism to weaken the JPY according to its needs.

Japan needs to kick start inflation expectations suggesting to us that there will be front loaded JPY weakness. Next to USDJPY we have recommended JPY crosses such as EURJPY and GBPJPY too. The outcome of the French Republican Party primary seeing the former PM Francois Fillon gathering 44% support followed by 28% for Alain Juppé, leaves the impression that the probabilities of a populist party winning may be in retreat. Fillon stands for a Thatcher-like reform agenda. Should he win next Sunday’s second round bailout too then a significant political risk to Europe’s political agenda may be now be sharply reduced allowing the EUR to rally. EURJPY looks lucrative.

Unsurprisingly, Germany’s Merkel will seek a 4th term when Germany votes in late September next year. The lack of credible alternatives makes her re-election likely especially in the context of Germany’s well performing economy. In October, Germany saw a very strong 8.2% increase in tax revenue. However, FinMin Schaeuble is not ready for fiscal expansion. According to ‘Die Welt’ Schaeuble wrote a letter to the European Commission urging EMU sticks to tight fiscal rules suggesting that EMU’s general consolidation efforts have been insignificant so far.

Zeng Xiangquan,head of the China Institute for Employment Research, estimated the size of China’s labor force dropping further in 2016,at the same pace as in 2015 if not faster, with the total decline in the five- year period 2012-2016 amounting to some 20 million workers. China steers its economy from the labour market side. Hence, a falling labour force reduces the need for China growing fast. We maintain our strategic call for AUD weakness.