Key Drivers on Tuesday

There are three key developments today:

First, Japan’s Prime Minister Kan won the DPJ party leadership contest against Ozawa. Ozawa had been a advocating material intervention and new fiscal stimulus. His defeat reduces those risks and has been a factor helping lift the yen today. The rating agencies quickly responded. S&P indicated it would maintain Japan’s rating, but that the quality was “slowly sinking”. Fitch said that the continuity of the Kan Administration was not something that drives its assessment, but it cautioned that a DPJ split could be negative for the ratings. Japan-watchers will be closely monitoring the potential cabinet reshuffle to see what happens to Ozawa supporters. If they are forced out, it would increase the likelihood that Ozawa himself would bolt. The yen may have also received a boost from speculation that China is not alone in buying Japanese paper to diversify reserves. Market contacts report that talk suggests that Singapore and Malaysia may have also done so.

The second important development was the stronger than expected UK inflation. August headline CPI rose 0.5%. The market consensus was for a 0.3% increase. This left the year-over-year rate at 3.1%. The core rate ticked up to 2.8% from 2.6%. The report means that again the BOE must write a letter explaining itself to the Chancellor. This inflation report may have more important implications too. After the triple-disappointing PMI reports, widening trade deficit and decline in property prices, talk of renewed QE had been picked up. The resilience of inflation is likely to cut short such speculation or at least postpone a more serious discussion. Earlier sterling had fallen to test support near $1.5340 in response to the sharp fall Nationwide home price index, with apparently less attention paid to the first rise in its consumer confidence measure after three months of declines. Resistance is now pegged near $1.5440.

The third important development today is the weaker than expected German ZEW survey. The key here is the that economic sentiment collapsed to -4.3 from 14.0 in August. The consensus had forecast a 10.0 reading. The fact that the current assessment actually improved was less material. It rose to 59.9 from 44.3. The discrepancy is troublesome and is consistent with a flattening out of the German economy, consistent with some of the recent PMI readings. Separately and earlier Germany had reported a unexpectedly strong rise in wholesale prices in August. The market forecast was for a 0.3% increase, which would have offset the 0.3% decline in July. Instead wholesale prices rose 1.6%, lifting the year-over-year rate to 6.4% from 5.3%. There has been some talk in the markets that the ECB’s stance may be too tight for some in the periphery, but it may be too easy for the booming German economy.

The Chinese yuan has appreciated at a faster rate in recent days. Of the past five days it has risen 0.66%. Most regional Asian currencies have risen a bit faster, but the yuan’s appreciation is notable. It is now at levels not seen since the unification of exchange rates in 1993. There are several possible explanations. Domestic considerations include greater confidence in the economy, as Premier Wen said, the economy is in “good shape”. Inflation stands near a 2-year high and a stronger currency is perceived to help on the margin (though with negative real rates on the key 1-year deposit rate, it is not clear how much a modicum of currency strength is worth). There may have been some international considerations. We note that Treasury Secretary Geithner has sounded a bit more disappointed with the pace of change. Yesterday some 93 members of the House of Representatives signed a letter requesting ta vote on a bill that would allow the US to impose countervailing and anti-dumping duties on countries that consistently have undervalued currencies. House Ways and Means Committee is to hold hearings China tomorrow with Geithner expected to testify and Thursday more of the same before the Senate Banking Committee.