Market Preview: Japanese rate decision vital to global risk appetite

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The Bank of Japan’s decision on interest rates on Wednesday is a crucial event for global asset markets in a relatively quiet week for data releases. Ultra-low Japanese interest rates provide cheap financing for “carry trades” where hedge funds borrow in yen and invest in higher yielding assets elsewhere.

Japan’s policy interest rate – the overnight call rate – stands at just 0.25 per cent but money markets are pricing in further increases. Concern is mounting that a rise in Japanese interest rates could provoke a rapid unwinding of some carry trades, spreading weakness across other asset classes such as emerging market currencies and equities. Investors need little reminding of how sharply sentiment can turn after last May, when the FTSE emerging markets index dropped by almost a quarter in just
five weeks. Policymakers have felt compelled to warn about the risks of a disorderly retreat and some dealers have described carry trades as “the most
widely forecast financial crisis in history”.

But analysts remain deeply divided over the outlook for Japanese monetary policy. A key factor behind the strengthening of expectations that Japanese rates will rise was the 1.2 per cent increase in fourth quarter gross domestic product, a stronger-than-expected performance. However, Japanese inflation remains low, and surveys suggest the pace of economic recovery will remain modest. Prior to the latest GDP data, the consensus forecast was for Japanese GDP growth to fall to 1.9 per cent this year from 2.2 per cent in 2006.

Steven Pearson, chief currency strategist at HBOS Treasury Services, says unwinding of carry trades would be accompanied by a material reduction in global risk appetite. However, this has not been observed in recent action in commodity markets or emerging market currencies. While much of the concern about carry trades has focused on possible changes in funding costs (ie higher Japanese rates), Mr Pearson notes that the potential returns on the long side of these strategies remains highly attractive and are key to the longevity of the phenomenon.

Germany GDP growth in the final quarter of last year proved much stronger than expected, rising 3.7 per cent compared with the same period a year ago. The breakdown of fourth quarter GDP is due on Thursday and the Ifo business climate survey for February, due on Friday, will provide a pointer to the 2007 outlook, which has been affected by uncertainty over the impact of the increase in VAT in January. The consensus forecast is for the headline Ifo to dip slightly from 107.9 in January to 107.7.

UK manufacturing saw a distinct loss of momentum at the end of last year and, partly due to the strength of sterling, a weak start in 2007 also appears likely. The CBI’s February Industrial Trends survey, due on Wednesday, is expected to show the volume of output measure decline from 12 to -5. Total orders fell in January while the expected prices measure jumped and a further rise would push it to a 15-year high.

The Bank of England’s Inflation Report suggested interest rates will need to rise by a quarter point to ensure inflation remains below target in two years time. The Bank’s February minutes, also due on Wednesday, will show if any policymakers dissented from this view.

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