Yen Rallies to 12-year High Vs. Dollar

The yen's surge today is sparked largely by speculative flows that were encouraged by the apparently low level of concern, or willingness to act, by Japanese officials.

It bears noting that the rally was not just against the dollar, which traded below JPY100 for the first time in about a dozen years, but the yen also rallied more than 1% against the euro and sterling. Of course the usual platitudes about excessive moves are undesirable and developments are being closely monitored. While there apparently were stops below JPY100, there was talk of strong bids as well near JPY99.80, by both investment backs and semi-official Japanese pensions.

Fundamental macro considerations are not nearly so yen positive. With today's drop of 3.3%, the Nikkei is off 32% from its high set a nearly a year ago (March 20). The unelected Prime Minister jammed through the budget and antagonized the opposition party that controls the upper house by dragging its feet for weeks and then finally nominating the one candidate for BOJ Governor that it had voted against when he became deputy. Meanwhile, the Ministry of Finance's (MOF) weekly portfolio flow data is not picking up much of the usual repatriation ahead of the fiscal year end on March 31.

While there had been some foreign bond selling by Japanese investors in mid-February, they have been net buyers of foreign bonds for the past two weeks for a total of JPY1.3 trillion (~$13 billion). On a net basis, the MOF data indicates that there was a net outflow of portfolio capital from Japan of JPY351.4 billion over the past week after JPY551.3 billion outflow in the prior week. As one would expect, implied volatility has jumped sharply higher at 15.67% (3-month), and it is below the high in August 2007 of near 17.5%. Officials note that the price action reflects dollar weakness rather than yen strength, which supports our assessment that the risk of unilateral Japanese intervention continues to appear quite small.

European officials also seem to be at a relatively low level of anxiety about the euro's push above $1.56. ECB President Trichet continues to toy with the market, adding marginally to his rhetoric applying "current circumstances" to his concern about "excessive foreign exchange movement".

The Federal Reserve's injections of liquidity provide an ample supply of dollars, while the ECB has barely reacted to a sharp backing up of Euribor, where the 3-month rate has risen over the past several sessions to 4.61% yesterday, where it is also today and which is the highest since Jan 7.

Meanwhile the Fed funds futures strip show that the pendulum of market sentiment is swinging back toward a 75 basis point (bp) rate cut next week. Here is another way to look at it: A year ago, the German 2-year bond yield at about 4% was 15 bp above the similar U.S. rate. Today, a 2-year German note yield is 3.24%, more than twice the yield of the U.S. 2-year Treasury. U.S. officials also do not show a high or even a moderate level of concern. In a TV interview yesterday, President Bush said the U.S. dollar is "adjusting", and neither he nor Treasury Secretary Paulson went beyond the usual mantra of how a strong dollar is in the U.S. interest. The relatively low level of official concern emboldens speculators and momentum traders and exaggerates the trends in place.