What Are the Markets Facing?

Japan’s economic outlook is starting to weaken as manufacturers are beginning to feel the affects of a strong Yen and U.S. downturn. Confidence among Japanese manufacturers in the first quarter fell to -12.9 from 5.2 the prior quarter, the lowest levels in four years. Additionally, small business owner’s expectations for the future declined as they are battling record oil and input costs. Their shrinking margins have forced them to reduce wages to their employees. Since, they account for 70% of jobs; this will ultimately weigh on personal consumption and the overall market. The BoJ which has attempted to maintain a policy of steady rate increases, have found themselves facing pressures to cut rates in the near term. Acting Governor Shirakawa’s statement today "We are monitoring with great interest the impact (of the market turbulence ensuing from the subprime woes) on economies of the world, the United States and Japan," clearly shows their mounting concerns. The clear issue for the central bank in cutting rates is the fear of rising inflation. Therefore, the upcoming CPI reading will go along way in determining the possibility of a future rate cut. Experts are predicting an increase to 0.9%, which would be the highest level in nearly two years.

Bonds – 10-Year Japanese Government Bonds

Japanese government bonds have started to form a triangle as world markets have continued to flip flop on their risk sentiment. The contract may be setting up for a breakout to the upside as speculation grows that the BoJ may cut rates. The expected increase in inflation may be a deterrent to cutting rates, therefore if CPI prints higher than expected it may weigh on JGB’s. However, a flat to inline reading will increase the prospects of a future easing and could lead to a breakout back towards 142.00.

FX – USD/JPY

The USD/JPY has recently found support as Japanese data continues to confirm that the world’s second largest economy is poised for a contraction. Emerging market demand has propped up the Japanese economy, but as the U.S. slowdown filters through its trading partners, it will continue to drag on the Asian economy. The paired recently failed to test its 20-Day SMA after risk appetite dissipated following the Fed’s 75 point rate cut and other measures to provide liquidity to the market lost their luster. The recent consolidation of the pair has set it up for a potential breakout with technical analysis targeting the 102 level. As speculation grows for a potential BoJ rate cut the pair will continue to generate support form dollar bulls, and a breach of the 20-Day SMA may set it up for further gains. A greater than expected CPI reading will inspire Yen longs, as an inline or lower print will do the same for their dollar counterparts.

Equities – Nikkei 225 Index

The Nikkei 225 Index has run onto trendline resistance after five days of gains. The continued weak fundamental data from the U.S. and Japan have led traders to decrease their expectations for future growth. As Japanese companies margins shrink due to rising input costs so will their future valuations. The upcoming expected rise in inflation will only heighten trader’s fears that managers will find it difficult to pass on rising costs onto consumers, and weigh on equities going forward. However, evidence that inflation is decelerating will increase the prospects for a future rate cut and in turn increase future valuations.

Terri Belkas is a Currency Strategist at FXCM.