Tankan Strong But Yen Isn't

The quarterly Tankan survey of Japanese Industry surprised to the upside printing at 24 versus 21 expected as business confidence was boosted by lower exchange rates which helped drive the critical Japanese export sector.

The yen however, did not respond to the good news as traders focused instead on the smaller than forecast increase in Cap EX which rose 11.5% against 11.8% consensus. Currency traders essentially bet that tonight's data was not sufficiently strong to motivate the BOJ to raise rates before year end and pushed USD/JPY to 118.41 before the pair retraced to its Friday close of 118.10.

Although temptation to chase yield remains understandable, we believe tonight's economic news will make USD/JPY carry trade progressively more perilous in the next few months. The dollar bullish case is predicated on the assumption that the Fed will resume rate hikes as US economic demand picks up while the BOJ will remain motionless.

In fact, the opposite scenario appears more probable. Last week US economic data from Durable goods to GDP numbers all proved disappointing. Notably, personal income increased as forecast but personal spending did not - a clear sign that the US consumer is now more focused on servicing debt rather than increasing spending.

This is a dynamic that the market may not yet fully appreciate as we approach the critical Christmas season. On the flip side, Japanese economy fuelled by persistently lower yen is enjoying a robust corporate recovery. When elevated corporate profits finally translate into higher wages, the BOJ will have no choice but to lift rates from their unnaturally low state.

In short, unless US economic data improves markedly in the next several months USD/JPY will have a difficult time challenging its 2005 highs as the market finally comes to accept the stagnant US interest rate environment.

Across the pond PMI data was better than expected in both Euro-zone and UK EZ PMI printed at 56.6 versus 56.5 the month prior as Industrial demand in the Euro-zone remained surprisingly firm in the face of what many analysts expected to be a month of slower growth.

Both German and French components met expectations with only Italy slipping slightly below consensus forecast. The news suggests that the Euro-zone industry continues to serve as a catalyst for growth in the 12 member region despite higher energy and interest rate costs.

In UK PMI printed substantially better than forecast at 54.4 versus 53 consensus. The report provided much needed ammunition to cable longs after last week's steep declines and GBP/USD dutifully bounced 50 points on the news.