Risk appetite: Basel III to BOJ

Initial reaction to the Basel III regulatory requirements was dollar negative as the market interpreted the proposed structure to be quite beneficial towards restoring a modicum of stability in the global financial system. The US unit was sold across the board as participants, probably spearheaded by hedge funds, rushed into “risk on” mode. The follow-through that occurred yesterday, aided by the Goldman Sachs article predicting more QE in the US, has to raise the possibility that dollar weakness may be in the early stages of exhibiting trend-like characteristics.The crux of the accord was to increase the capitalization(core capital as a percentage of risk adjusted assets) requirements to 7% for the major banking institutions. This means that banks can either raise more capital or reduce their exposure to riskier assets in order to meet this benchmark. The latter option might entail a substitution of the risky assets with safer government bonds which in turn would lower the domestic rates in the respective countries.

In a “risk-on” environment this would bring the now famous “carry trade” back into vogue and high yielding currencies, like the Aussie, could be the beneficiary of flows seeking higher returns. The Aussie was last at these levels in mid-April, when “all was well” with the world and right before the European issues came to the fore. The breach of 0.9400 might be signaling that the trifecta of strong Aussie employment data, strong Chinese economic data and the implications of the Basel accord could be the impetus this currency needs to finally reach parity versus the US dollar. Key levels(~0.9550/~0.9650/~0.9730/~0.9790/~0.9850) will have to be breached and there cannot be any more unpleasant shocks to the global financial system, but macro factors seem to be aligning in such as way as to make this scenario a reality.

Given this apparent shift in market perception, it was surprising that the Yen was continuing to exhibit strength. One can only conclude that the market participants were so convinced of its trend that it would take an extraordinary event to shake them out of their beliefs. Apparently the Japanese authorities felt likewise because at around 9:30 PM EST yesterday, they intervened in the market, their first such foray in about 6 years. USD/JPY, which was trading around 82.90, ratcheted up to the mid 84’s within the next 30 minutes and has subsequently traded as high as 85.70. While intervention is seldom successful in the long term, the fact that they used EBS for the first time ever, leads one to believe that they have drawn the proverbial line in the sand at 83 and are willing to intervene further to keep their currency from appreciating dramatically. A move higher in USD/JPY to the 88 – 90 area seems likely over the coming days. That said, the fact that this was a unilateral operation, in that neither the EU or the US was involved, would indicate that the market will likely test the resolve of the Japanese authorities around these levels in the coming weeks.

Akhilesh S. Ganti
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