Capital Spending (YoY) (1Q) (23:50 GMT)
Expected: 10.1%
Previous: 16.8%

Capital Spending ex software (YoY) (1Q) (23:50 GMT)
Expected: 10.3%
Previous: 17.6%

How Will the Markets React?

From officials’ language and previous interest rate decisions, it is clear that the Bank of Japan wants to bring its nation’s overnight lending rate to a more normalized level. Though, a recent cooling in economic growth and the persistent deflationary conditions in Japan have made it a very difficult venture. Typically, where there is strong growth, inflation follows. This has not been the case for the island nation though where a clear clog in the normal economic cycle at consumer earnings and spending has blocked the flow. Should this persist for too long, this impasse will certainly hold up a more aggressive rate policy and could eventually end the impressive trend of economic expansion, the longest since WWII. This places substantial pressure on business spending and exports to keep things moving. So, what should the market look for to determine whether the tides are changing and Japanese workers’ earnings and spending are rising so that inflation may be stoked? While there is monthly data that monitors things downstream, it is better to look to the source – business earnings and investment. The general level of confidence at Japanese firms has already been established by the quarterly Business Sentiment Index and Tankan reports. In the first quarter, the BSI reported a significant deceleration in the manufacturing sector to a one and a half year low, though the broad all industry report held relatively firm with a 6.2 percent increase. At the same time, the Tankan manufacturing and service surveys were relatively consistent, with the former actually holding at its recent record high. Beyond confidence, the recent GDP report for the first quarter may give a better look into actual capital spending. The capital investment component fell only 0.9 percent following a 3.7 percent drop in the final quarter of 2006; though this isn’t very promising since personal spending for the same period cooled to a 0.9 percent pace of expansion from 3.5 percent.

Bonds – 10-Year Japanese Government Bond Futures

In the past few weeks, JGB yields have risen significantly as data has crossed the wires in support of a Bank of Japan rate hike by the July meeting that interest rate futures markets have priced in. The rally in yields began in earnest back on May 24th and 25th when the annual national consumer price index finally printed an unchanged pace after a few months of declines. The fundamental run only improved as time went on with the jobless rate hitting a nine year low, household spending picking up and earnings rebounding. With the nearby 10-year JGB futures contract already well below 133, traders will be looking for data to further fuel downside momentum. With capital spending expected to slow though, the steady rise in yields may be coming to an end.

FX – USD/JPY

The USDJPY cleared the 121.80 hurdle on Friday, as the Japanese yen was one of the only currencies weak enough for the US dollar to trump. However, the pair still looks shaky as price teeters at the apex of a large ascending triangle, and the release of economic data during the next Asian session could propel USDJPY to the January highs near 122.20. Capital spending during the first quarter is anticipated to slow sharply to 10.1 percent from 16.8 percent, signaling that expansion in Japan is becoming ever more reliant on consumer spending. This would not be entirely surprising, though, especially after first quarter GDP showed that capital spending contracted 0.9 percent while personal spending grew 0.9 percent. Nevertheless, a poor reading once again will only hammer in the dour sentiment on the Japanese yen, as the Bank of Japan has little hope of hiking rates in the near term.

Equities – Nikkei 225 Index

Japanese shares gained in Asian trading, with the Nikkei 225 Stock Average up 0.5 percent to 17,958.88. The increase was led by automakers on speculation that Toyota Motor Corp.'s US sales rose in May and that the company will report higher-than-estimated earnings for the first quarter. Toyota shares jumped 2.2 percent to 7,460 yen while Denso, Japan's biggest auto-parts maker which is 23 percent owned by Toyota, advanced 1.4 percent to 4,330 yen. Meanwhile, miners advanced after prices of crude oil and metals climbed. Nippon Mining, which made almost 80 percent of its sales from oil refining, advanced 2.7 percent to 1,099 while Mitsui & Co., which trades industrial fuel and metals, jumped 2.9 percent to 2,470.

Next week could spell trouble for Japanese equities, as capital spending growth is estimated to slow sharply in the first quarter. While this would not be entirely surprising given the 0.9 percent decrease we saw in the capital spending component of first quarter GDP, the data would not bode very well for the economy as a whole since the weight of expansion would rest on consumers’ shoulders. Now, the Nikkei 225 has already breached resistance at 17,825, but still sits below the psychologically important 18,000 level. Will the bullish sentiment of the equity market keep the index surging towards the February highs of 18,300.39? Perhaps, especially as signs of softer economic growth can be construed as a factor to keep the Bank of Japan from raising rates. With stock markets around the globe reaching for new highs, it’s very likely that the Nikkei 225 will follow suit and hold onto its recent gains regardless of how Capital Spending fares.

Terri Belkas is a Currency Analyst for FXCM.