USD.JPY

Merkel in the Spotlight 
 
By John R. Taylor, Jr.

Over the past two years, Germany has become an ever-stronger behemoth standing over the European continent, pressing its agenda in every forum and winning its point most of the time. Right now, the rationalization of banking risk and several important steps toward a more fiscally-centralized system for the Eurozone are opposed by critical members of the German establishment and would be subject to a veto by the Bundestag. As a result there is no progress on resolving several central and critical issues impacting the viability of the euro experiment and the slow transition to an as-yet- unresolved steady state future for those countries involved. Although there seems to be a strong feeling that everything will come out just fine in the end, there is no reaching that state of nirvana without passing through Berlin. Right now Berlin is closed. Most observers see the Germans as unable to make any of the hard decisions necessary to move to the next level until the Federal election process is behind them on September 23 and Merkel and the CDU/CSU have been crowned as the winners. It is not that the Merkel coalition is the most friendly to Europe, as the SPD and the Greens would make a more euro-friendly team, but Merkel is the devil we all know and, whether we outsiders admit it or not, it seems we are more in favor of the conservative approach of the current German team. The polls strongly support a Merkel victory, so she will be “The Man”, more so than today, the person that will dictate the next steps in the euro drama.


What surprises us is that many, many people, both informed and less so, believe this and comment that things will begin to move again after the election is over and Merkel is reinstated. We can’t help but ask: Why? Even if Merkel becomes more politically secure than she is today, the ice could still crack beneath her. The CSU, her Bavarian co-party, is always restless on the right and will force positions that Merkel might find objectionable if left to her own desires. The FDP, Merkel’s minor partner is struggling to survive, as it needs 5% to win any seats in the Bundestag and the CDU/CSU depends on them. Their most recent election rhetoric has helped to crystallize its unhelpful euro view. None of this will help Merkel move toward the consensus of the Eurozone leaders and their desire for a sharing of monetary responsibility and burdens. Although one might argue that an SPD/Green coalition would be better for future European relations, the uncertainty it would generate would probably be worse for the first year or so, especially as the Bundesrat situation would likely see a quick reversal next year. The most likely conclusion is that German politics won’t be stable enough to allow Merkel to change her stance, and even if it were, there is no sign her coalition or her team would be interested in changing. As we see it, not one hair on Merkel’s head will be moved. The hope of a rapprochement between Germany and France, plus the rest of Europe will keep things under control through the end of September at a minimum and more likely into year-end as the grim reality will be hidden behind closed doors for quite a while. But by the start of next year, the chasm between the others, some in their 9th quarter of recession by then, will be too wide to bridge. Draghi and other enablers could allow the euro to hang tough through the 4th quarter, but there should be a test in the next month or two as the reality of a recessionary second half dawns on the complacent majority.


The Unequal Nature of Hedging Yen Risk 

By Jonathan Clark

The Japanese stock market has been the strongest in the world in the past seven months, gaining nearly 80%. This has attracted a great deal of global attention, as the second-best performing market during this timeframe was the Argentina Merval Index, which gained 45% in a country where inflation is more than 10%. Abenomics, the economic policies of Japanese Prime Minister Shinzō Abe, should continue to increase confidence in the Japanese economy, boosting both spending and investment. In addition, these policies weaken the yen, which stimulates exports. We are expecting that after a pullback during the next two months, equities will strengthen into the end of the year. Although this should attract offshore funds into the Nikkei, this doesn’t mean the yen has to strengthen. The chart shows the performance of the Nikkei 225, which we index to the returns of the same Nikkei index in US dollar terms starting at the middle of October of last year. Sophisticated offshore investors that buy the Nikkei will often sell yen to hedge the currency risk. Hedging is clearly the right answer. The interest rate differentials tend to drive spot rates and, for more than two months, interest rates in Japan have been rising versus those in the US. We doubt money will flow into Japan to invest in Japanese Government Bonds when the 10-year only pays 0.85%. Abenomics is intended to drive money out of safe investments by lowering interest rates on government bonds (not working thus far) while hiking inflation. Negative real interest rates will force investors to take more risk and this will result in money flowing offshore. Sophisticated Japanese investors won’t hedge because they expect government policies will result in a weakening yen, thereby increasing the overall return on offshore investments. April marked the start of the Japanese fiscal year, historically the month investment decisions are made. As a result, we expect increased offshore investments. Data backs up this theory, as in recent weeks, Japan’s life insurance companies and pension funds became net buyers of foreign bonds.


USD/JPY should trade higher into late next week, when an intermediate peak is due. If it surpasses our initial target of 102.75, it can trade as high as 104.25 before forming a medium-term peak. Dollar/yen should then pull back for several weeks before the uptrend resumes. By the week of June 3, the JPY will resume its uptrend to September and this overall strength is likely to last to the end of the year. Our longer-term objective is the 109.00 area. The support at 99.40 should hold into the end of next week and if seen is a good place to buy. Only a close below this means dollar/ yen will make an aggressive decline to the 97.50 area in early June, but this outlook is far less likely.