Key Forces and Implications

The summer lull in the foreign exchange market ended abruptly this week and the reverberations will likely carry into next week’s activity. As the week draws to a close, it might be helpful to summarize them and draw out some implications.

BOJ Intervention: The first intervention in six-years, and what still appears to be a record single day amount, managed to lift the dollar three yen. There has been some international criticism, but not from ministers of finance, central bankers, or of course prime ministers. U.S. Treasury Secretary Geithner did not address the intervention in yesterday’s appearance before the Senate committee. With the intervention funds settling today, and no offsetting BOJ operation to mop it up, it still appears to have been unsterilized.

In terms of policy, if the BOJ does not come back at the start of next week, the market may begin testing its resolve. Talk of dollars bids (quasi-official?) in the JPY85.30-50 range. The intervention has also sparked speculation that the BOJ will take some additional measures at the early Oct policy meeting. Such measures could include extending the JPY30 trillion facility, cutting 0.10% it pays on reserves, which acts as the floor for rates and increase JGB purchases (rinban operations. Moody’s said today that the BOJ has greater scope to expand its balance sheet.

What Japan will do with the dollars it purchased is fairly clear and obvious: Treasuries and agencies. The market anticipates this bid. It is also important to consider what the Japanese banks will do with the yen they were given. Clearly the government hopes they lend to businesses, but corporate Japan is sitting on a large cash surplus as it is. Second choice, the Japanese government hopes that the banks sell the yen and buy foreign. There had been strong Japanese portfolio capital outflows in July, but the pace has slowed more recently. The weekly MOF report may take on new interest. The funds could also simply sit in the money market or further out on the curve.

Swiss Doves Cry: The market appears to have an outsized reaction to the SNB comments yesterday. There was one Swiss bank that had forecast a hike, so most had fully expected a stand pat policy. Growth and inflation forecasts were cut, which also was not really unexpected. Many had begun thinking, though that a tightening move could take place in December or possibly March next year.

The seemingly dramatic reaction would suggest that such expectations have been dashed. However, recall that the SNB spent billions to weaken the Swiss franc last year and earlier this year with little success. There seems to be something more going on than dovish comments. It seems that the squeeze of on Swiss longs may also be one of the unintended consequences of the BOJ’s intervention. Popular yen crosses were also popular Swiss franc cross positions. The intervention triggered an unwind of the long yen positions which in turn has forced an unwind of franc positions. This also plays into the hands of the risk-off matrix, with dollar-bloc currencies and Scandis (Sweden’s election is not expected to result in a change in government) and emerging market currencies all getting a boost.

Yuan Move: China’s yuan posted its biggest advance this week in a little more than two-years. There were a couple US Congressional hearings this week and it is clear that US officials, including the Administration are increasingly frustrated. Geithner stepped shy of endorsing any of the bills that are working their way through the legislative process.

The G20 meeting is in early October and China has way to make some high profile move prior to such meetings, especially where it faces criticism. Look for our weekly SpecialFX piece “Observations Early in the Pacific Century” for a discussion of the role of the yuan in Japanese intervention, the amount of which was close to the amount of Japanese paper (mostly bills) that China purchased in the first seven months of the year (according to Japanese data).

QEII: Talk of QEII in the US appears to have been one of the factors weighing on the dollar by driving lower. And we continue to point to the widening of the Us-Germany 2-year spread as an important tell of the euro-dollar direction. That rate differential favors Germany by the most of the year have widened sharply this week. The FOMC meets next week and although even the QEII camp thinks it is too early. However, another cut in the forecasts for 2011 and this may aggravate the pressure on the dollar. That said, note that the door to more QE seems open in the UK and Japan as well.