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Markets: Volatile markets in earthquake aftermath
Earthquake in Japan drives market volatility. The currency market gyrated post the Japan earthquake. Yen weakened initially on limited damage, but quickly reversed course on repatriation concerns as the Tsunami image flooded the screens and the worries about the nuclear reactors grew. The trend reversed again when the Bank of Japan (BoJ) decided to flood the market with large amount of liquidity in the same day with operations to the tune of ¥15tn.

The JGB market rally rode on the flight to safety, but the back end suffered on the fear of a worsening fiscal situation and insurance company selling. Japan events eclipsed an important development in Europe as the 17 euro nations proposes to allow EFSF to buy government bond in the primary market, increase the EFSF's power to its full allotment of 440bn, and reduces the loan rate to Greece. The action resulted in stronger EUR.

Policy action in Japan determines JGB and yen direction. The data is light in the calendar. The market will be watching the policy response by Japanese government. It is a given that the BoJ will ease in terms of monetary policy, but the way it does this matters to the JGB yield in the face of increasing concern on Japan's fiscal situation. The yen will likely depend on whether Japan intervenes in the currency market.

Focus: Japan earthquake - impact on FX and rates, by Bin Gao, Adarsh Sinha and Tomoko Fujii
Following the tragic earthquake in Japan, market volatility has risen sharply, underlining the significant uncertainty around the economic cost and how this will be met. We outline our early thoughts on the likely impact on the JPY and JGBs, keeping in mind that the situation has many unknown factors and we will provide updates as it develops.

Implications for JPY
The sharp JPY rally on Friday was attributed to anticipation of financial inflows following the earthquake - specifically those relating to insurance payments. At this point, the magnitude of insurance payments is highly uncertain, with press reports citing estimates ranging from $10bn to $35bn. As reference, the most expensive earthquake from an insurance perspective was the 1994 earthquake in California, which cost $20.6bn (in inflation-adjusted terms). In Japan, earthquake insurance is underwritten on the assumption of government reinsurance, which will limit the hit to private insurers to some extent. The current limit on losses covered by the government and the private-sector insurers is ¥5.5tn ($68bn), of which the limit for private-sector insurers is ¥1,198.75bn ($15bn).  

The size and impact of these inflows are very uncertain but we expect them to be modest. There are three types of inflows being anticipated:

n    Reinsurance inflows from overseas: These will likely increase in coming quarters, but the positive flow effect on the JPY should be limited as the payments will be staggered over time as claims come to light. The influence of these flows on the overall current account balance is also likely to be small. In 2010, the insurance balance deficit was Y483.2bn ($5.8bn), compared to the overall current account surplus of Y17.1tn ($194.6bn). After the Kobe earthquake in 1995, the insurance balance deficit narrowed by Y70.2bn over 1995-96, part of which would have been related to reinsurance payments (Chart of the Day). However, this is a small amount in absolute terms, as well as its limited impact on the current account balance.

n    Repatriation by domestic insurers to meet payments: Japanese life and nonlife insurers will need to liquidate part of their domestic and foreign asset holdings to meet insurance payments. In the FX market, Japanese life insurers are much bigger participants than nonlife insurers. At the end of 2010, life insurers' foreign securities holdings (including JPY-denominated foreign bonds) totaled Y44.5tn (about $548bn), compared with only Y4.9tn ($59bn) for nonlife insurers. Life and nonlife insurers' actual reductions of their foreign asset holdings were limited in the aftermath of the Kobe quake. Their foreign securities holdings rose from Y20.6tn ($206.6bn) at the end of December 1994 to Y21.2tn ($237.6bn) at the end of March 1995 and dropped to Y20.0tn ($240.9bn) at the end of May 1995 (Chart 1).

n    Non-insurance related repatriation due to risk aversion: Because of Japan's large positive net international investment position, the JPY exhibits a strong degree of home bias. Chart 2 shows the foreign asset positions of the whole economy - three large components will arguably not have a huge FX impact: bonds (generally currency hedged particularly with interest rate diffferentials having been so narrow), reserves (which are relatively stable and the MoF/BoJ are unlikely to want the JPY to strengthen), direct investment (by its nature sticky). Except for equities, all other remaining components have not materially increased since the 2008 financial crisis. This leaves repatriation of foreign equity positions as potentially representing the most signifcant upside risk for the JPY, although significant rotation from foreign to Japanese equities seems unlikely given the local nature of the disaster.

Do not extrapolate the USD/JPY collapse post-Kobe earthquake. This is partly because the fall in USD/JPY, particularly in March 1995, was related to various other factors including a broad dollar sell-off alongside a slide in US yields, as well as a sharp sell-off in Japanese equities related to the collapse of Barings and the Mexican crisis. Even assuming the earthquake influenced the price action, Japanese bank balance sheets were at the time very sensitive to the stock market, raising the need for repatriation as stocks collapsed. This is less likely to be the case now.

FX intervention is one of the few policy tools available, with interest rates already close to zero. With domestic demand and sentiment likely to be weak for some time, external demand could take up the slack. JPY strength is primarily related to anticipation of one-off flows, rather than underlying fundamentals, indicating there is a strong case for Japan to intervene if needed. For the first time in a while, the G7/G20 is unlikely to raise any objection to intervention given the crisis backdrop in Japan.

In the short-term we are wary of the risks from the liquidation of short JPY positions, particularly those held by domestic retail investors as well as the general slowdown in outward investment by Japanese investors that is likely following the crisis. However, our discussion suggests that the medium-term inflows are unlikely to lead to significant JPY strength from current levels, particularly given the risk of intervention. We continue to expect USD/JPY to enter a moderate upward trend by the middle of this year.

Implications for JGBs
Curve bull-steepens when disaster hits ... When a major disaster hits as a surprise, the yield curve typically bull-steepens with the market expecting the central bank to respond with easy monetary policy in the short run. The market tends to overreact for one to two weeks before the curve reverses its move (Chart 3). The curve reaction is consistent across markets except in Australia's case when the curve started steepening before the flood turned out to be weaker than feared when it hit Brisbane.

... But the initial reaction may be different this time for JGBs. It might be problematic if one simply extends the above observation to the current JGB market. Because policy rates are at zero, there is only limited room for the front end to rally. The ¥7tn BoJ's new liquidity injection, though through repo, will likely get a bond market rally flattening the curve initially at least to the 7y futures sector. 2s10s will likely follow the same trend but with smaller magnitude. Or alternatively, the same steepening in JGB may happen in the 5s20s, rather than 2s10s given the 5y point in zero rate environments behaves more like the 2y point in a normal time. The more interesting question is what happens next.

The JGB may get heavy on demand supply tips. After the initial JGB rally on the flight to quality, the fundamental concern remains for the supply-demand imbalance. It is arguably worse now than it was before the earthquake. The megabanks position in JGB remains heavy and the cash on their balance sheet light. Such a position potentially magnifies bearish moves in JGBs. Several factors favor such a move, although the final quake costs will affect the outcome significantly.

n    Companies were the major source of deposit growth for banks, which in turn bought JGBs. The lack of power and the disruption to the production of upstream auto and electronic products in the hard hit northeast area will likely impact the corporate cash build up down the road.

n    Insurance companies have enough reserves in catastrophe loss-reserves (estimated at ¥1tn at March 2010), but they need to sell-assets which will add pressure to the bond market. To make the situation worse, insurance companies' holding of JGBs has steadily climbed from 32% to 42% of their asset portfolio, and the average duration has also gotten longer.

n    The government budget is already in a dire shape with JGB issuance higher than the tax revenue. Any help from the fiscal side will worsen market fears on Japan's debt concern. Furthermore, if the insurance cost runs higher than ¥1.2tn, the government will have to bear a additional cost up to ¥5.5tn, further threatening the market with higher JGB supplies.

The wild card sits in BoJ's hand. The BoJ looks like the only party which can provide the needed support for JGBs if rates shoot higher down the road. Of the ¥35tn asset-purchase program it has announced in the past, the BoJ has used up 30tn, leaving out ¥5tn it can inject immediately.

de BNP  CE MATIN....

 Diverging risk factors for credit spreads this morning. On one hand, the earthquake in Japan is risk-negative at least in the short term due to the outright drop in activity in the region as well as repatriation flows back into Japan with the potential; to driving the yen higher, although BoJ is already trying to counter this with big injections of liquidity in the market.
At the same time Middle East tension remains elevated, with reports over the weekend that Bahrain which saw heavy demonstrations and clashes on Saturday has requested Saudi troops to enter the country (and rumours this morning that Saudi troops are already in).
The good news came from Eurozone summit which surprised on the upside with an increase of the EFSF, better borrowing terms for Greece and an extension in the EFSF mandate to buy sovereign debt in primary (and possibly
secondary?) markets. Having said that, the Ireland situation remains unresolved with a stand-off between the new government threatening senior haircuts in exchange for lower borrowing costs and ring-fencing the low corporate tax rate still going.
iTraxx indices have given most weight to the Eurozone developments at the open, gapping tighter and not surprisingly financial spreads are outperforming in the move as the sovereign crisis sees another couple of steps un the right direction.

* The statement of the Euro Area over the weekend included the following points which should be broadly positive: (i) the new post-2013 ESM programme will be able to lend up to EUR500bn through gradual increases in paid-in capital, called capital and guarantees; (ii) in the meantime, the EFSF will have an effective lending capacity of 440bn, an increase in its effective lending capacity of around EUR250bn; (iii) interest for Greece will be reduced by 100bps and repayment extended to 7.5 years as Greece undertakes the privatisation of EUR50bn worth of assets; (iv) the EFSF will be allowed to carry out interventions in the primary market; but (v) no agreement has yet been reached on Ireland which refuses to lower its tax corporate rate in return for a reduction in borrowing costs. On balance, the support package is good news given (i) the interest burden on Greece is lowered and the refinancing hump in 2014 is spread out more evenly and (ii) the EFSF will now be able to buy bonds and we expect more details on how this might be done over the coming days. At headline level this looks positive for sovereigns and financials. The negative news is focussed on Ireland which did not see a similar reduction which could lead to negative rhetoric and headlines relating to defaults on its bank debt. On the back of these developments, Eurozone sovereign and financial spreads (ex Irish banks) should outperform corporates near term as systemic risk premia subside further.



10:50 Écrit par swingteam-cc | Lien permanent | Commentaires (0) |  Facebook |

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