Europe
Enough Italy Bashing
Oct 27, 2006

Eric Chaney (Paris)

The downgrade of Italy by two credit rating agencies is likely to re-invigorate a theory that has some popularity in the financial markets, namely that Italy could well be the first casualty of an ill-conceived monetary union.  The rationale: Italy has suffered from a huge loss of competitiveness, its productivity is at a standstill and its public debt is running out of control.  Real life has demonstrated that the country cannot compete with her neighbours on a level playing field, i.e., not without the repeated ‘shots in the arm’ provided by devaluations.  According to this line of reasoning, investors should ultimately impose a higher risk premium and, as debt servicing becomes more costly, their pessimism would turn into a self-fulfilling prophecy: Italians would start dreaming of a 1992-style devaluation as the only way to bail out their flagging economy, at the expense, of course, of their main trading partners.

I am afraid that the script of this horror movie is based on flawed macroeconomic analysis and poor use of dubious statistics.  On the contrary, I believe that Italy is on the mend and likely to attract considerably more foreign capital than it has done in the past.

First, three key hard facts do not square with this ‘Italy bashing’. Since the inception of EMU, Italian GDP has increased by 1.33% per year versus 1.31% for Germany.  I wonder which economy was the sickest. Italy’s trade balance was in perfect equilibrium in 2005, with the non-oil balance posting a hefty 2.4% GDP surplus.  In contrast, Britain’s and Spain’s trade deficits were, respectively, 5.6% and 7.6% of GDP last year.  Last, Italy’s harmonised unemployment rate dropped from 11.4% just before EMU started, to 7.4% on the latest reading, only two points above the UK level.  This is a much larger decline than in France or Germany and comes second only to Spain.  Italy bashers, who are at pains to explain how a lame duck could manage to reduce unemployment without fuelling wage inflation, may question the quality of unemployment statistics.  However, these measures are based on large-sample household surveys and are therefore more reliable and consistent than claimant counts, which are reliant on national unemployment insurance systems.  Nevertheless, they have some idiosyncratic features on which I will comment later.

So why are so many analysts convinced that Italy has been priced out of the game by super-competitive Germany?  Because they look at measures of competitiveness such as unit labour costs or export volumes.  On these criteria, the Italian situation looks truly desperate.  Take, for example, the relative unit labour costs in the manufacturing sector calculated by the EU Commission.  On this measure, Italy’s competitive position relative to its euro area partners has lost 23.5% since 1999 while Germany’s position has improved by 17.6%.  There is worse to come: on the OECD measure of real export market performance, Italy has lost 27 points of market share since 1999, twice as much as France, while Germany has gained 4.1 points.  Clearly, something must be wrong: how could an economy suffering enormous losses of competitiveness boast a falling unemployment rate and a balanced trade account?

In my view, both unit labour costs and export volumes are tainted by serious statistical uncertainties.  Starting with unit labour costs, the weak link is not the measure of costs, but that of productivity, a notorious headache for statisticians.  On data gathered by the US Bureau of Labour Statistics, Italian hourly productivity in manufacturing was the same in 2005 as it was in 1999, while it increased by 27% in Germany and France over the same period.  I find it hard to believe that Italian hourly productivity has really stagnated for six years, and suspect that a combination of large-scale regularisation of illegal immigrants and tax incentives for employers to hire employees who were working without being recorded in payrolls have distorted productivity data.  In short, hundreds of thousands of workers in Italy have moved from the black to the legal economy, artificially bringing down productivity data and probably flattering unemployment numbers as well:  It is likely that black economy workers answered ‘No’ when asked the question ‘Are you working?’ in the household survey, and now say ‘Yes’ if they have been hired legally in the meantime.

In fact, since the output of the underground economy is included in GDP as measured by ISTAT, it is fair to say that both past productivity and past unemployment levels were artificially inflated and that current data are closer to reality.  From this angle, the fact that a four-point cut in the unemployment rate did not fuel wage inflation becomes less intriguing: in reality, unemployment has declined less than official measures suggest.   Back to productivity, the rate of growth was underestimated because of these changes in the structure of the labour market.  In the real world, hourly labour productivity has probably increased in Italy about as fast as in the average of mature economies, as a result of technological progress and capital deepening.  The problem is that we do not know exactly at what rate.

Turning to exports, here is the conundrum: standard indicators say that Italy’s competitiveness has been seriously eroded and, yet, Italian exports are doing well, compared with its peers.  On OECD data, Italy’s market share of global trade, measured in current dollars, was 3.7% in 2005 versus 4.1% in 1999, a 10% decline.  The OECD bloc suffered from the same loss — its market share dropping from 74.5% to 66.9% over the same period, in favour of China and oil-exporting countries.  A more relevant measure of Italy’s export performance is to compare its nominal exports with those of the euro area.  On this yardstick, the only one that really makes sense in a currency union, Italy actually outperformed its peers: Italian nominal exports have increased by 4% more than the average of EMU country exports since the inception of the monetary union.  Here, I believe that the statistical flaw is in the measure of prices.  In reality, for lack of a direct measure, ISTAT is using unit values, i.e., export values divided by quantities.  When the euro shot up, in 2002-03, a very counterintuitive fact was that Italian export ‘prices’ (in fact unit values) increased.  In my view, this point, which escaped analysts’ attention, reveals the underlying and hidden truth: Italian producers have reacted to globalisation by off-shoring production centres to low-cost countries such as Romania and Tunisia and, more importantly, by upgrading their product mix towards more expensive products, in the fashion sector to take a well-known example.  Here again, the problem is that there is convincing indirect evidence, such as the export performance, that corporate Italy has changed for the better, but no direct and reliable statistics.

Don’t get me wrong.  I’m not saying that Italy is the new corporate Eldorado or the next stellar macro performer in Europe.  The public debt inherited from the past is a permanent sword of Damocles.  Labour laws, especially redundancy rules, are rigid, corporate governance is weak, the internal market is inefficient, especially for services, the commercial property market is opaque and in the hands of a small group of investors, bureaucrats and their love affair with ‘documenti’ are not particularly business-friendly, the population is ageing, pension reform is still ‘a work in progress’ and healthcare reform is still in limbo.  And yet, at the margins, Italy might be the place where change is taking place at the greatest speed.  In this regard, Mr. Prodi’s strategy is the right one, I believe: commitment to budget consolidation, reduction in non-wage labour costs in order to boost employment and reduce further structural unemployment, and supply-side reforms such as the liberalisation of services.  In fact, I would have a wager that the credit rating agencies may sooner rather than later have to re-evaluate the Italian case in a more positive light, given faster potential growth and lower budget deficits.  Investors should not wait until then.

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Japan
Reform Momentum Strengthens Daily
Oct 27, 2006

Robert Alan Feldman (Tokyo)

Economics

In the economics area, a number of personnel appointments bode well, in my view. For example, PM Abe has appointed Prof. Masaaki Homma, formerly a member of the Council of Economic and Fiscal Policy (CEFP) under the Koizumi government, to head the Government Tax Council. Prof. Homma has been a forceful advocate of reform, and will likely marshal the powers of that Council to support the growth agenda. In addition, the two new senior staff under Takumi Nemoto, who is the PM’s Advisor for Fiscal and Economic Policy, were both deeply involved in the Koizumi reforms, one as special assistant to former Minister Heizo Takenaka and one a key staff member for the highly successful Industrial Revitalization Corporation of Japan (IRCJ).

Key elements of the economic policy platform are also becoming clearer. For example, in the tax reform area, three major items are high on the agenda: tax deferrals for international triangle mergers, a reduced corporate income tax rate, and highly accelerated depreciation schedules. All three are gaining momentum, especially in light of the positive attitude of Finance Minister Koji Omi — a former METI official with a pro-growth philosophy. In addition, to put meat on the bones of PM Abe’s vision of 4% growth, Minister Sanae Takaichi has taken charge of The Council on Innovation for 2025. This council includes key reform-minded members of the scientific community, such as Dr. Kiyoshi Kurokawa, a former professor of medicine at UCLA, who has been a forceful advocate of reform in both medical and science areas.

In addition, earlier uncertainties have been resolved. When the Cabinet was first formed, there was some confusion about where the locus of economic policy making would be, with Economics Minister Hiroko Ota or with PM Advisor Nemoto. PM Abe has given clear instructions:  Ms. Ota will be in charge of the economic policy agenda, and Mr. Nemoto in charge of several key initiatives, such as the Asia Gateway project, the reorganization of the Social Security Agency, and public relations on economic policy. Moreover, an earlier problem was promptly corrected. The crucial Council on Educational Reform, a task force to redesign the education system and make the nation more competitive, started with 17 members. This structure drew criticism as unwieldy. However, PM Abe has already re-organized it into three subcommittees, with different reporting and action schedules.

Politics

Political developments also favor the new government for now. In weekend elections, PM Abe’s Liberal Democratic Party (LDP) won both by-elections for the nation Diet, erasing the aura of defeat that had surrounded the party ever since its loss in a by-election in Chiba Prefecture a few months ago. Moreover, the LDP is opting for clarity of message over political compromise. LDP Party Secretary Hidenao Nakagawa insisted in a speech last Thursday that ex-LDP members who were expelled last year for rebellion on the Postal Reform issue would not be allowed back into the party. The idea is simple:  The voters will not trust the LDP if it re-admits those who opposed the LDP’s key policy action.

For the opposition Democratic Party of Japan (DPJ), in addition to election losses, there are other worries. First, the DPJ is no closer to a unified position on major policy issues (such as defense and agriculture) than ever. Moreover, DPJ President Ichiro Ozawa has recently suffered from health problems. Indeed, he missed the first Party President debates in the Diet a few weeks ago. It will be challenging for Ozawa to lead the party as vigorously as he would like, in my view. Moreover, Mr. Nakagawa has recently stepped up the political attack on Ozawa, claiming policy inconsistencies. Finally, the DPJ is still having difficulty finding candidates for next year’s Upper House election.

Foreign policy

The Abe government has scored points with investors and voters in foreign policy as well. PM Abe’s early trip to China signaled his desire to revive political relations between the two countries. Although dangerous, the North Korean nuclear test underscored the importance to both China and Japan of the need to work together. Hopes are growing that the very broad set of forward-looking issues facing the two countries will now overshadow the backward-looking problems of the last few years. Moreover, PM Abe’s forceful reiteration of Japan’s commitment never to possess nuclear weapons has calmed fears in the region that an arms race might start in the wake of the North Korean tests. China is surely grateful for Japan’s restraint on this issue. Thus, a positive tit-for-tat game may have started between the two countries, laying the groundwork for the evolution of cooperation (see Robert Axelrod, The Evolution of Cooperation, Basic Books, 1984).

Market implications

My sense is that the focus on quarterly earnings is so strong now that investors may be missing the positive evidence on the new government. Indeed, some optimists are beginning to think that the Abe government may exceed the Koizumi government in comprehensive reform measures. So far, the earnings season has been good, and equity prices are up. When investors wake up and smell the policy coffee, I believe that the sustainability of profits will seem better, and equity markets could well rise further.

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Japan
Japan
Oct 27, 2006

Takehiro Sato (Tokyo)

Nationwide core CPI weakens, but rays of light in Tokyo metropolitan core

The nationwide core CPI rose 0.2% YoY in September, while the Tokyo metropolitan core CPI was up 0.1% as of mid-October. Though the nationwide core figure was weaker than the market had anticipated, the Tokyo metropolitan core came in slightly higher than our reading. The US-style core CPI figures, excluding food and energy prices, also showed wider margins of decline in rents and clothing, which brought the nationwide number down further to a 0.5% YoY decline.  Conversely, an increase in rents, apparel and healthcare prices narrowed the decline in the Tokyo metropolitan US-style core figure to -0.1% YoY.  The data were clearly mixed.  However, a decline in gasoline prices since late September has yet to leave a mark on the nationwide core CPI. This is because price data are gathered either on Wednesday, Thursday or Friday of the week including the 12th of a given month, and thus biased to the first half of a month. On the other hand, we did see an impact from the decline in crude oil prices on the Tokyo core CPI figure. We expect little movement, around +0.2% YoY, for the nationwide core CPI in October, despite an increase in healthcare co-payments for the elderly that will push up prices.

Other types of core figures and major sources of volatility: 1) Baseline, 2) US-style core, 3) Trimmed mean estimator

The Japan-style core CPI includes some types of food and energy, so it tends to rise faster than the other three core CPI estimators when the crude oil prices remain high. Below we discuss current figures and the outlook for each of these estimators.

1) Baseline (core of core): This excludes special factors like broadly defined public charges and energy prices. In September, the nationwide baseline CPI fell 0.15% YoY after a 0.10% decline in August, while the October Tokyo baseline core CPI fell 0.03% YoY after a 0.16% decline in September. In the nationwide baseline, the pace of improvement in the baseline has slowed since June and it looks to have almost stalled at the moment. However, the core of the core for Tokyo metropolitan showed the first noteworthy improvement in nearly a half a year. 

The interesting point this month is that the upside/downside contributors flip-flopped between the September nationwide and the October Tokyo metropolitan results.  In regards to apparel, we expect the positive contribution in the October Tokyo metropolitan CPI to show up in next month’s October nationwide CPI.  However, any upward/downward movements in the Tokyo metropolitan imputed rents won’t necessarily show up in the same direction in the nationwide figure in the following months, based on this item’s track record.  Because of this, we think that risk in the October nationwide CPI would be, if anything, on the downside. 

2) US-style core CPI: The nationwide US-style core CPI fell 0.5% YoY in September, while the Tokyo US-style core CPI fell 0.1% YoY in October. Although the decline in the nationwide figure expanded by 0.1ppt, the Tokyo metropolitan decline narrowed by 0.2ppt.  This irregularity in the nationwide and Tokyo metropolitan figures fits with the trends noted above in the baseline.  However, the US-style core still lagged behind the core of the core. 

3) Trimmed mean estimator: The BoJ looks at this (which trims the top and bottom 10% in terms of the components weights), along with the Japan-style core CPI (excluding fresh food), to get an idea of the basic direction of prices. The nationwide trimmed mean estimator rose 0.15% YoY in September, compared with a 0.2% YoY rise in August. This is also consistent with the trends shown above for the core of the core CPI. 

Core inflation rate forecast

From a bottom-up perspective, it appears that prices will continue to see downward pressure from strategic reductions in utility rates stemming from deregulation, as well as from a downward trend in telecommunications rates. In addition, the decline in the price of crude oil has been influencing prices for gasoline and other petroleum products since October. As a result, the core inflation rate is likely to slow despite: 1) an increase in healthcare co-payments for the elderly that began in October; and 2) a disappearance of the impact of falling mobile phone rates due to base effects that will start in November.

In addition, a 1% fall in the crude oil landed price produces a fall of about 0.3% in the market prices of petroleum-based products. Petroleum-based products account for about 3% of the CPI, so a 10% decline in the crude oil landed price would result in a 0.1ppt decline in the core CPI inflation rate. The WTI futures is already about 30% below its most recent peak, so one should keep in mind that the core CPI margin could fall near zero depending on crude oil prices.

In light of the current outlook for broadly defined public charges revisions between now and March of next year, as well as our new crude oil price and forex forecasts, we think the core inflation rate will be +0.3% QoQ in October-December through C2007, or basically flat YoY.  The average for F3/2007 should be +0.2% (C2006: +0.1%) and for F2008 +0.3% (C2007: +0.3%). Our estimates could be lower than the revised estimates that the BoJ will release at the end of this October (in our view, the BoJ is likely to expect a core CPI of 0.3% in F3/2007 and 0.5% in F3/2008).

From a top-down perspective, wages and employee income are more sluggish than the consensus view, while growth in unit labor costs remains below sea level on a YoY basis. Therefore, productivity continues to rise. All of these things are helping to keep prices stable.

Future productivity growth depends on things like wage and capex trends. We think wage growth will remain low and stable for the next one to two years. In addition, we think capex will continue to rise gradually, although we also think growth will slow in F3/2008. Both factors should help boost productivity. Moreover, significant slack (manpower, capital, land, etc.) exists in regions outside of major metropolitan areas, so we think that the economy has an unusually large amount of excess supply capacity. In any case, both a bottom-up and top-down perspective appear to indicate that commodity prices will be extremely stable.

Monetary policy: interest rate hikes depend on economic fundamentals

Based on the price outlook discussed above, we think that the BoJ’s interest rate policy will remain rather measured. At the same time, many market participants assume that the BoJ will not raise interest rates further due to a sluggish core CPI rate. This could be wrong, however. 

This is because the BoJ ended its commitment to using the core CPI inflation rate as a benchmark for monetary policy when it terminated quantitative easing in March. This means that economic fundamentals are more important, and if it appears that fundamentals will be strong enough, then a low inflation rate will not necessarily stop the BoJ from raising interest rates. In addition, the fall in the price of crude oil will not only help stabilize commodity prices, but it could also lead to increased demand in nations that consume oil. Too much focus on prices could cause one to misread future policy.

Going forward, we expect two rate hikes of 25bp each, one in January-March of 2007 and one in July-September. We think the first increase will come in January. There are three main reasons for this. First, we think that the December Tankan survey will indicate improved corporate sentiment and profit forecasts, as the BoJ has expected. Second, the July-September GDP could end up higher than we initially expected thanks to the large improvement in net exports. Finally, we may see a moderate bounce-back in October-December quarter GDP, mainly in the domestic demand-related components. On the other hand, the Japanese government drafts its initial budget in December, so an interest rate hike is unlikely then as it would be delicate politically.

Some segments of the market assume that the new pro-growth cabinet will mean increased pressure on the BoJ, but we are not so sure. That the BoJ took small steps toward normalizing monetary policy in March and July this year, even with leadership of the ruling parties pushing a reflation policy, is evidence against this view. If the economy is healthy enough, then an interest rate hike would be to the advantage of both the government and the BoJ. In any case, if the economic outlook is benign, then the BoJ will likely continue raising interest rates at an extremely measured pace. On the other hand, an uncertain economic outlook would likely mean a longer interval between rate hikes.

Given the above, the time span for rate hikes could be unusually long, and the policy rate could end up at about mid-1% towards 2008. Even so, Japan’s policy interest rate would still be well below the neutral rate of 2.5-3%. We think that Japan’s financial environment will continue to be extremely accommodative, thanks to yen depreciation caused by a de facto carry trade spurred on by overseas households.

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Currencies
Central Banks Contributing to Low FX Volatility?
Oct 27, 2006

Stephen Jen (London)

Summary and conclusions

Why is implied and actual volatility so low in the currency markets?  The absence of structural pressures on the dollar index and low risk-taking by investors in the currency space are two primary reasons.  A third possible contributing factor could be central banks’ reserve management style, whereby they tend to target benchmarks by buying more of the currencies that are depreciating and selling the currencies that are appreciating.  When risk-taking by private sector investors was high, this stabilizing force from central banks was not so visible.  However, once private sector risk-taking abated, this factor came into sharper relief.

This central bank investment pattern, however, is likely to change over the medium term, in my opinion.  Specifically, if incremental reserves are deployed through ‘sovereign wealth funds’ to invest in riskier but higher-return assets, central banks could evolve from a source of stability to a source of volatility in the coming years.  

An elaboration of my thesis

Though implied volatility is low across the currency, bond and equity markets, actual volatility has been particularly low in the currency markets.  Why have exchange rates been so stable in recent months? 

In my writings, I have proposed two hypotheses to explain this, in addition to the familiar point that volatility in all markets has somehow experienced a structural decline since 2003.  First, our valuation framework suggests that the G7 dollar index has been almost perfectly valued for most of the year.  Thus, from a valuation perspective, there should be no great structural pressures on the dollar.  The modest deviations in some bilateral exchange rates could be explained by special factors: EUR/USD could be above its fair value because of the ‘liquidity premium’ of the EUR, while USD/JPY is overvalued to reflect the yield differentials and the declining ‘home bias’ in Japan. 

Second, risk-taking has evaporated in the currency space, even though there is plenty of risk-taking in the bond and equity markets.  This could be due to asymmetric globalization complicating the way currency markets trade or behave.  Specifically, globalization may have significantly distorted the currency markets, more than it has affected the bond or the equity markets.  These distortions have, over the past three years or so, ‘wrong-footed’ many investors who had deeply ingrained theses on the dollar that no longer worked in this new world.  For example, the dollar’s failure to crash in the past three years, despite the outsized C/A deficit, and the massive overshoot in EUR/JPY have surprised most investors and, as a result, may has temporarily eroded investors’ confidence in trading currencies.  Until risk-taking returns, implied and actual volatility may remain low, and carry trades could be justified. 

In this note, I offer a third explanation for why volatility is so low in the currency markets.  This idea is built on two notes I have written: Sovereign Wealth Funds (September 14, 2006) and Official Reserves a Source of Stability, Except in 2002 (September 28, 2006). 

In my piece on official reserves, I argued that central banks, in the aggregate, offset movements in exchange rates by buying currencies that were depreciating and selling those that were appreciating, so as to maintain their nominal benchmarks.   In other words, contrary to the popular view that central banks have been behind the ‘mini-attacks’ on the dollar as, one by one, central banks ‘defected’ from USD, based on the latest IMF data, central banks have in fact been a source of stability in the currency markets.  The exception to this was in 2002, when there was a step adjustment in the currency composition of reserves, in favor of the EUR. 

In my piece on the ‘sovereign wealth funds’, I argued that, gradually, central banks that have more than enough reserves for liquidity purposes could start to either explicitly divert some of their reserves into ‘sovereign wealth funds’ or implicitly have multiple tranches in their reserves to allow more risk-taking of a part of the reserves.  At present, the ‘sovereign wealth funds’ total some US$1.4 trillion, based on my own guesstimates, but this is likely to grow by at least US$200-300 billion a year for the foreseeable future. 

I make two key points:

•           Point 1.  Central banks, in some circumstances, could really depress currency volatility.  For every 1% fall in the value of the EUR, central banks need to buy roughly US$8 billion worth of EUR to maintain their benchmarks.   If I am correct that central banks, most of the time, maintain their benchmarks, then they should normally ‘lean against the wind’ by buying currencies that depreciate and selling currencies that appreciate.  Once in a long while, the benchmarks may be modified, but this doesn’t happen often.  What this means is that in times of low liquidity and risk-taking, such as now, these flows from central banks could be quite a powerful stabilizing factor for the currency markets.  

•           Point 2.  Central banks’ role evolving from a source of stabilization to a source of volatility?  In the coming years, if central banks divert more of their financial resources into sovereign wealth funds, their investment pattern will be significantly altered.  As central banks broaden their targeted asset classes away from the liquid sovereign debt markets to less liquid higher-return markets such as equities, real estate and credits, companies will matter more than countries, and the non-G3 assets may benefit at the expense of the USD, EUR and GBP assets.  The JPY should, in theory, be a beneficiary of this process as the Nikkei, and not just the JGBs, will be included in the portfolios of sovereign wealth funds: Japanese equities are not a part of the Asian reserves now. 

The super-low volatility environment will not last

Notwithstanding the above discussion on how central banks’ reserve management may affect currency volatility from a structural perspective, I believe that exchange rates will likely break out of the familiar ranges before the year is over, as private sector investors raise their risk-taking activities: the Asian currencies should reassert themselves. 

With an absence of pent-up structural pressures impinging on the dollar (I have never subscribed to the popular view that 2005 was a ‘bear market rally’ for the dollar, and that the dollar would inevitably resume its structural descent), cyclical factors will continue to drive currencies, in my view.  I personally think that investors are ‘trying too hard’ and paying too much attention to daily data releases.  What is much more important is to take a stand on the big-picture view on the global economy. 

On one hand, there is the ‘hide-from-the-storms’ scenario, whereby the US falls into a deep recession, centered on a collapsing US housing market, and the challenge to investors is to find shelter in this fear-filled, unpleasant environment. 

On the other hand, there is the ‘search-for-the-bluest-patch-of-sky’ scenario, whereby what we are witnessing is a very benign global rebalancing of growth.  The US-centric global recovery since 2002 was never meant to be a lasting pattern.  A soft landing in the US would be healthy, particularly if the rest of the world continues to recover, despite the slowdown in the US. 

In the ‘stormy’ scenario, the best currency trade would be to buy the dollar, as latent short-dollar positions in the market would be unwound, leading to a rally in the dollar, particularly against Asian and other emerging markets currencies. 

In the ‘blue sky’ scenario, however, the Asian currencies should perform well.  This, in fact, has been my central case all along.  Asian equities should perform well, and foreign capital should be re-deployed there.  As a result, the Asian currencies will rally.  This is how we can evolve from a ‘bond culture’ to an ‘equity culture’, and from a world driven by nominal yield differentials to one where real economic fundamentals drive currencies.  I believe that we may be witnessing the beginning of this process. 

The Fed is likely to be on hold for an extended period, and the rest of the world will be able to keep normalizing rates to ‘catch up’ to the Fed, in my view.   USD/CNY, in this scenario, should continue to be guided lower, to my recently revised year-end target of 7.70.  The JPY could indeed be forming a medium-term bottom here against both the USD and the EUR.  AXJC currencies should resume their upward trend that was interrupted in May/June. 

Bottom line

In this note, I propose one possible explanation for the super-low volatility in the currency markets: reserve managers’ investment pattern of leaning against the market to maintain their currency benchmarks.  Having said this, I expect risk-taking of private sector investors to recover before the year is over, as a more constructive outlook for the global economy should start to support the Asian currencies.  Moreover, in the coming years, I also expect the investment pattern of reserve managers to shift to make them less of a source of stability for the currency markets. 

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