Japan is Officially Back into Recession

The dollar traded in a range through most of the trading day, and still hasn’t broke out in early European trading. But the lack of volatility in the currency markets has been seen as a good sign for the commodity markets, which are pushing higher.

The big news impacting the markets overnight in Asia is the larger-than-expected drop in Japan’s GDP during the first quarter. The earthquake and tsunami are the main culprits behind a 3.7% annualized decline in Japanese GDP from January-March of this year. The drop was larger than economists expected, and the equity markets throughout Asia sold off. Since this was the second consecutive quarter of contraction, the Japanese economy is now back in recession.

Pfennig readers know that Japan has been struggling to post consistent growth numbers for several years now, and that it was the first of the major economies to use quantitative easing in order to try and stimulate their way out of trouble. But in spite of throwing huge amounts of liquidity at the markets, the Japanese economy continues to languish. That is one of the problems with QE, if the people who get the freshly printed money don’t put it into circulation, it just doesn’t work.

One of the core problems in Japan is that the Japanese consumers just don’t want to borrow and spend. The Japanese have always been proficient savers, and typically shy away from leverage. This lack of spending has been compounded by the deflationary environment, as there is just no incentive for consumers to spend today when prices may be cheaper tomorrow. While interest rates have been near zero for over a decade, those who want or need to borrow probably already have. Some will say it is horrible for me to say, but this year’s catastrophes may actually be a good thing for their economy, as they will force spending.

The problems in Japan are more complicated than what I have laid out, but the theme is that things are not going to get better in Japan for some time. The Japanese economy is now the smallest size since 1991, and the data indicate that it will continue to shrink in the coming year. But currency investors know that just because an economy isn’t performing, the currency can still shine. The yen (JPY) is still seen as a safe haven for many investors, so I don’t expect a precipitous drop in the value of the yen even with the economy slipping back into recession. Don’t take that as an endorsement for the yen, I would stay away and look more toward the Singapore dollar (SGD) for Asian exposure.

The other big news in the markets overnight was the resignation of Strauss-Kahn as the head of the IMF. Denying the charges, Strauss-Kahn said his resignation would be effective immediately. The markets have been expecting this, so the news really didn’t have much of an impact. But it does officially open up the negotiations over his replacement. Europe and the US are backing another European to take over at the IMF. In particular, Christine Lagarde, the French Finance Minister, is the front-runner. She is certainly qualified, and having a woman replace Strauss Kahn may help quiet calls for a change at the top of the IMF.

But the emerging markets are loudly rebuffing suggestions that the new leader has to come from Europe. Russia, South Africa, and Brazil have all expressed their dissatisfaction with leaving the leadership of the IMF with a European. And the Asian economies would like to see someone from their area at the top spot. Europeans have held the top job at the IMF for 65 years, and these emerging economies feel it is time to give a finance minister from one of their countries a shot at running things.

Emerging markets have definitely become more important in the global recovery, after the credit crisis rocked the developed countries. The IMF has been instrumental in the terms of the European bailouts, and many believe these terms were less onerous for Europe than the terms given to emerging markets looking for help from the IMF. Many believe having a leader from an emerging economy would focus the IMF on these countries, which will help drive global growth in the coming years.

While I expect a lively debate, the Europeans will maintain control of the IMF with the help of the US. The Europeans have always held the top job at the IMF while the US gets the top job at the WorldBank. There is just too much at stake right now in Europe, and consistency at the top of the IMF is what is needed. I think Legarde will become the first female chief of the IMF in the next few weeks.

The euro (EUR) was unchanged versus the US dollar during the past 24 hours in spite of some pretty tough news. ECB officials ruled out a Greek restructuring, clashing with political leaders who want to see a quick solution to the crisis. The ECB is siding with the large European banks, which would lose if the debt is extended. “A Greek debt restructuring is not the appropriate way forward – it would create a catastrophe” because it would damage the banking system, ECB Executive Board member Juergen Stark said today.

Political leaders just want to get a deal done so they can get this over with. But the ECB wants Greece to come up with a better solution than to just extend or forgive the debt. The problem is, a Greek default will be even more devastating to the European banks.

The Swiss franc (CHF) dropped slightly as Swiss investor confidence dropped for the first time in three months. The index of investor and analyst expectations that aim to predict growth in the next six months fell to minus 11.5 from 8.8 in April. The Swiss economy is showing some signs of slowing down as the sovereign debt crisis and a strong franc have combined to increase downside risks. Swiss Central Bank President Philipp Hildebrand suggested that a renewed economic recession seems ‘unlikely’ but risks to growth remain ‘substantial’.

The minutes of the last FOMC meeting were released yesterday, and policymakers have begun to think about reversing the record amount of monetary stimulus. But thinking about it and actually doing it are two different things. The board agreed that any action should be taken in small steps, as they do not feel inflation pressures are increasing (while food and fuel prices just continue to tick higher!) The report said the talks over the exit strategy don’t mean that tightening “would necessarily begin soon”. So don’t expect any action unless there is a ‘significant change’ in the economic outlook. All indications are that the FOMC will not be making any moves to remove the stimulus in 2011.

Today we will get the weekly jobs numbers, which are expected to show another 400K+ were added to the unemployment rolls last week. Continuing claims are projected to have decreased slightly, as the long-term unemployed continue to drop off the roles. We will also see existing home data along with the leading indicators for April.

As I mentioned up top, commodities rallied after a government report showed that US crude inventories dropped unexpectedly. The spot price of crude oil climbed back above $100 after the report showed that US stockpiles slipped 15,000 barrels last week. Projections were for a rise of 1.7 million barrels, so the difference was pretty dramatic.

The increase in oil prices helped boost the Canadian dollar (CAD) and Norwegian kroner (NOK), two big exporters of the black gold. Raw materials, including oil, account for about half of Canada’s export revenue, so a strong oil price will keep the loonie well bid. The Brazilian real (BRL) also moved higher on petrol prices and expectations of a widening interest rate differential. Indications that the FOMC will be leaving rates low for some time have made the higher rates available in South Africa, Australia, and Brazil even more attractive for investors.

Gold climbed through the trading hours yesterday, but then dropped in early European trading. Silver climbed yesterday, and was able to hold on to the gains in trading today. The South African rand (ZAR) strengthened for a second day this week, gaining the most in a month versus the US dollar.

The New Zealand dollar (NZD) rose for a third day as the budget released today projected a surplus of 1.3 billion NZ$ in the year 2015. Standard & Poor’s said the country’s budget was consistent with its current ratings, which was definitely a sign that a downgrade was not likely. Concerns over a possible downgrade had caused many investors to sell the kiwi and move into ‘safer’ havens of the Japanese yen and US dollar.

Singapore is probably our favorite Asian currency on the trade desk. Their central bank uses the value of their currency to combat inflation, so higher prices are a good thing for the Singapore dollar. Singapore had the best growth rate of all Southeast Asian countries, and the government has raised its growth forecasts for 2011. GDP will increase 5%-7% this year according to government estimates. The economy expanded an astonishing 22.5% in the three months through March from the previous quarter. The report caused the Singapore dollar to rise, bringing the advance versus the US dollar to 13% over the past 12 months. Again, rising prices and solid economic fundamentals make the Singapore dollar a favorite of our trading desk.

Recap: The Japanese economy slipped back into a recession, and doesn’t look to recover anytime soon. The IMF is looking for a new chief, and the emerging markets want a non-European at the top. The minutes from the last FOMC meeting suggest they will be looking for an exit from QE2, but don’t look for an interest rate increase anytime soon. Commodities rallied, helping push the CAD and NZD higher, and our favorite Asian currency, the Singapore dollar, got some good news.

Chris Gaffney
for The Daily Reckoning