Last month we offered three unorthodox views: that the U.S. economy was proving more resilient than many recognized, a skepticism over how much more the yen would weaken on Abenomics, and that "currency wars" were being exaggerated and took our eyes of the real fissures, which are within countries rather than between them as was the case in the 1920s and 1930s.
These views are now more widely shared. Economists have revised up their U.S. GDP forecasts, the yen is trading at its best level in more than a month, and currency wars jargon has died down.
We take this opportunity to adjust our views.
1. As economists adjusted their forecasts for the U.S. economy, it is more difficult to maintain positive surprises. In addition, the economy appears to be finishing Q1 on a soft note that is likely to carry into Q2, which reinforces the seasonality component to some of the U.S. data. We would still argue that the U.S. economy has proven resilient and in particular, the consumer. It appears that the household de-leveraging process may be ending, which is something that needs to be monitored going forward.
2. One of the reasons that there has not been a stronger reaction to the losses inflicted on the uninsured depositors in Cyprus is because it is not unprecedented. There is a general procedure for insolvency: Management loses their jobs, shareholders lose and then unsecured creditors, followed by senior creditors, and finally uninsured depositors. How deep one has to go depends on several variables, including the capital structure. In effect, there must be enough capital among the shareholders and some (junior) creditors to fully absorb the loss before turning to secured senior creditors and uninsured depositors.
In the U.S., the most recent example of uninsured depositors being forced to take a loss was in the IndyMac Bank in 2008. Those uninsured depositors lost around half their funds. That was also before the deposit insurance cap was raised to $250,000 from $100,000. There were obviously serious problems in the U.S. financial system at the time, but the loss suffered by uninsured depositors did not cause them or spark a flight of deposits.
3. When investors have been able to look beyond Cyprus, Italian politics seems to be next worry, though the politics of Slovenia is also rivaling for attention. Rather than Italian politics per se, there are some increasingly worrisome signs in the real economy, but also in the financial sector. The March manufacturing PMI (44.5) is the lowest since last August and the forward looking orders slumped since last May. Output and employment are at seven month lows. The general reduction of Target2 imbalances continued into February. The notable exception was in Italy, where its liabilities rose by 28 bln euros, the largest increase in about a year and reverses the improvement over the past six months. In addition, unlike most others countries' central banks, the Bank of Italy increased its borrowing from the ECB for the first time since last July. Without putting too fine of a point on it, these figures point to increasing financial strains in Italy.
4. There are a number of indicators that are warning investors to be cautious about Japan. The big trade for many currency hedge funds, which are off the best start for a year in a decade, has been long Japanese stocks and short the yen. The options market in each is warning that the players are getting increasingly nervous. The premium for (3-month) dollar puts over calls is the largest in over a year as the bulls buy downside protection. The same is generally true of the Nikkei, where investors are buying downside protection.
The Nikkei gapped lower earlier today and was unable to fill the gap, which extends from 12107.40 (today's high) to 12133.00 (Monday's low). The technical tone will weaken if this gap is not filled in the next day or two. The most recent weekly (through March 23) MOF report indicated that the 19-week streak of non-resident equity purchases came to an end. Recent data has shown little impact from the decline in the yen on exports, industrial production, capex plans, or deflation. A recovery in the yen is also consistent with our expectation of softer U.S. economic data, which will prevent new yield advantage for the dollar. Former support for the dollar around JPY93.50 may now act as resistance.