The yen comes back into focus

The yen comes back into focus as the UK consumer makes a mild return

The yen carry trade and Japanese interest rates are gaining a lot of attention on Tuesday morning. The governor of the Bank of Japan wrote a letter to the Japanese government, explaining the decision to raise rates in July. He also said that the BOJ will continue to raise interest rates ‘if the economy and prices perform as expected’. The yen is higher on the back of these comments, and USD/JPY is testing the 146.00 level. The yen is the top performing currency in the G10 FX space on Tuesday. Stocks are higher this morning in Europe and US stock index futures also pointing to a higher open later today. Stocks are gaining alongside the dollar on Tuesday.

Why Japan fears are overdone  

The yen story is worth watching closely. Some analysts believe that rising Japanese interest rates could be the canary in the coalmine for the current stock market rally and may trigger unexpected volatility. There is some excitement that Japanese investors will trigger a wave of capital flowing out of the West and back into Japanese capital markets, alongside an end to the carry trade. While some re-shoring of Japanese capital may be expected, we do not think that this should induce any panic or risk aversion. The Japanese respect diversified portfolios, a lot of their foreign investments may be locked in for some time, and Japan’s demographics means that investment flows from Japan to Europe and the US will not dry up.

The mispricing of US rate cut expectations

Added to this, the market is still not expecting the BOJ to normalize interest rates quickly. There are currently only 9 basis points of tightening priced in by December, and 23bps by July next year. Even if the market adjusts these expectations higher, Japan is still set to have lower interest rates than elsewhere. Added to this, there is a chance that the market has mispriced US interest rate expectations. There are still 100 bps of rate cuts expected by the market by December. The interest rate market and the US stock market are telling different stories about the strength of the US economy: the S&P 500 is close to record highs, suggesting economic health in the US, whereas 4 rate cuts in three Fed meetings suggests economic weakness. If the non-farm payrolls report this week is stronger than expected, we could see interest rate cuts get priced out of the market, and a strengthening of the US dollar, which may lead to concerns about Japanese capital flows out of the west consigned to the past.

UK consumer shows signs of life in August

Elsewhere, the UK consumer is showing signs of life after a mixed performance in recent months. The better weather in August helped like for like retail sales to grow by 0.8% last month, according to the BRC. This was the largest monthly increase since March. The 0.8% increase is fairly moderate and is less than the 1.3% average monthly gain of the last 2 years. Thus, life is unlikely to get any easier for UK retailers, who will be hoping for a bigger pick up in the months leading up to Christmas. Next is one of the weakest performers on the FTSE 100 so far on Tuesday morning, and we could see more pain for UK retailers as the UK consumer remains lackluster.

M&A a key driver of UK stocks, as Rolls Royce recovers  

We continue to think that M&A activity will be a key driver of UK stock markets in the coming months, after Rightmove was the latest UK-listed firm to receive an offer from Murdoch-backed rival REA. Its share price is down 1.9% on Tuesday, and it is currently the worst performing stock on the UK index. This comes after its stock price surged higher by more than 20% on Monday after news of the offer from REA broke. REA has until the end of the month to firm up its offer. If Rightmove is taken over, then it would be a loss to the UK market.

Rolls Royce came under pressure on Monday after Cathay Pacific grounded some of its Airbus fleet due to a faulty part made by Rolls Royce. Its shares fell 8%, however, they are recouping some losses on Tuesday and RR is currently the second top performing stock on the FTSE 100 and is up some 3.4%. If we see more news flow that suggests RR is not at fault, expect a stronger recovery in the stock price. YTD, RR is still the best performing stock on the UK market and is higher by more than 60%.

US economic data watch

The US will be in focus today after the Labor Day holiday on Monday. Nvidia and the AI stocks will be watched closely to see if they can continue to recover after last week’s deep sell-off. The US ISM Manufacturing index is also due for release. It is expected to climb back to 47.5 from 46.8 in July. Last month’s report spooked markets about the strength of the US economy, thus, the new orders and employment components will be watched closely.

Volatility in focus

It is worth noting that markets are reactionary right now and have not latched onto any themes as investors return after the summer break. Thus, they remain susceptible to volatility. The Vix is currently trading above 15, which is slightly higher than the 1-year average of 14.84. As mentioned above, elevated USD/JPY volatility could also spook the markets. USD/JPY 1-month option volatility is currently 12, which is significantly higher than the 12-month average of 9.