Reduction in Risk Continues to Support US Dollar

The Japanese yen is benefiting the most from the current bout of reducing risk trades. Month-end demand by Japanese corporates may also be helping the yen recovery from roughly week lows against the dollar and two month lows against the euro. Dollar support is seen near JPY90.60 today and then JPY90.20/30. Japan's Sept retail sales were stronger than the market expected rising 0.9% on top of the 1.0% rise in Aug and 0.5% in July. The July-Sept quarter is the first since at least 2000 when retail sales rose each month. The Sept figures may have been flattered by the five-day holiday (Silver Week) this year. However on a year-over-year basis, Japan's retail sales are still off 1.4%, the smallest decline in nearly a year. Tomorrow Japan reports Sept industrial production. The strong gains that were recorded at the start of the fiscal year (5.9% in April and 5.7% in May) have not been sustained. Each month since May has been weaker and following August's 1.6% increase, the consensus looks for something closer to 1%. The year-over-year decline continues to moderate, bottoming in February with a 38% contraction. In August the pace of decline had been cut in half to 19%. The forward looking expectations for Nov may also be noteworthy. Lastly, note the BOJ meets this week, kicking off a series of major central bank meetings next week (FED, ECB, BOE, RBA). Decisions on the commercial paper and corporate bond purchases are awaited. The new government, like previous governments, may share the economic assessment of the BOJ but also seems to prefer to want to continue the supportive programs.

The US dollar is firm against most of the major currencies, save the Japanese yen. It is generally trading within yesterday's ranges, but dips have been shallow. We see two conflicting forces at work. Although we have a positive medium term dollar outlook, we recognize that a key short-term fundamental consideration, namely short-term interest rate differentials, remain dollar negative. At the same time, we respect the technical key reversal in the euro on Monday and the underlying shift in sentiment toward reducing some risk exposure, which is supportive of the greenback, which we have argued (and is finding greater agreement among other observers and investors) has been weighed down by its role as premier funding currency. Connect the dots: Several Asian countries (South Korea, Singapore and Hong Kong) have encouraged banks to tighten lending standards recently. Two high profile opinion shapers have argued that the risk trades have become, well, more risky. The fact that the UK economy unexpectedly contracted in Q3 and a sense that the momentum of the recovery is easing also may be encouraging some unwinding of risk trades. Lastly, we note that in Europe, "the too big to fail" conundrum is increasingly being resolved by the breaking up of large financial firms. The front page of yesterday's Financial Times was about ING being dismembered and today's news is about a similar fate for several UK banks. Although there are some in the US pressing for a similar course of action, Fed Chairman Bernanke and Treasury Secretary Geithner do not appear in that camp.