Looking ahead to Q3: is Japan building up to a fiscal crisis?

The second quarter is ending on a high note. Stocks are higher across Europe, the oil price is falling, and expectations for Fed rate hikes are moderate as we lead up to Kevin Warsh’s speech on Wednesday, and the US payrolls report on Thursday. The second quarter has been dominated by stunning gains for chip stocks, and tech-heavy indices, a strengthening dollar that has sent the yen down to a 40-year low and shifting geopolitical risks that are playing out in commodity markets.

The key numbers for Q2 include:

• A 59% gain for South Korea’s Kospi
• An 88% gain for the Philadelphia semiconductor index
• A 23% gain for the Russell 2000
• A 22.5% gain for the Nasdaq
• A 9% gain for the Eurostoxx 600
• A lowly  3% gain for the FTSE 100
• A 2.2% loss for the yen vs. the USD
• A 10% decline in the gold price
• A 15% decrease in the silver price
• A 30% fall in Brent crude

These numbers tell a story. The AI trade is still robust, even if it has splintered in recent months, with the chip makers surging and the hyperscalers struggling. Physical commodities are out, in favour of tech indices. The US and Asia are leading the pack, while Europe lags, and a strong economic outlook in the US is boosting the smaller cap Russell 2000 index, which was also a top performer this quarter. The Dow Jones is ending the quarter at a record high above 52,000, which is another sign of US economic dominance.

While the rally in Asian stocks is almost exclusively driven by chip makers, and chip-linked stocks, the rally has broadened in the US, as growth prospects remain firm. The Atlanta Fed GDPNow model is predicting growth of 2.5% for the US this quarter, this justifies the shift in US interest rate expectations. Interestingly, the shift to a slightly more hawkish stance from the Fed is driven by growth prospects and not inflation concerns, as you can see from the sharp drop in some commodity prices in the last 3 months. With growth lagging elsewhere, it supports a divergence in monetary policy in Q3 and beyond, which could play out in the forex market later this year.

Diverging rate hike expectations are also playing out in the yen. It dipped to a 40-year low, and USD/JPY is above 162, and is rising again on Tuesday. This is intervention territory, and FX traders will be wary of what the Japanese authorities do next to try and stem the decline of the yen.

The market is punishing the yen for a few reasons: 1, the BOJ is not hiking interest rates fast enough, 2, the new government is being accused of a lack of fiscal discipline. The second point is important, the Japanese government has removed Ministry budget caps to meet its new growth framework, prioritizing ‘effective investment’ over spending caps. This is increasing concerns that Japan’s debt to GDP ratio of 260%, will only expand further. The government is also suspending some value added taxes, and the $2.3 trillion long-term investment road map is a gamble when the country is also drowning in debt.

The yen has fallen to multi-decade lows, at the same time as long-end Japanese bond yields have surged this quarter. The 10-year Japanese bond yield is higher by more than 30bps in the last 3 months, this compares with a 30bp decline in Italian yields over the same time frame, and a 13bp decline in UK bond yields of the same duration. When yields rise but the currency falls, it suggests fiscal stress is building.

Thus, as we move into Q3, the yen is worth watching. There is now an enhanced chance of intervention risk and excess yen volatility, combined with a growing risk of a fiscal crisis in one of Asia’s biggest economies.

Overall, trades made today will settle tomorrow, the first day of Q3, so today’s price action could give us a clue about what to expect over the summer months. The focus will also shift to central Bank speakers at the ECB’s conference in Portugal. So far, ECB members have sounded hawkish about inflation risks, but the main event will be Kevin Warsh’s speech on Wednesday. We may drift into the event risks coming up in the next few days.