Japan: Rooting for a USD Rally     

• The Nikkei 225 has quickly rebounded back to 10,000 and JPY has backed off 14-year highs, mainly on the hope that the BOJ's JPY10 trillion program, worth some 9% of its balance sheet, is the precursor of a more proactive (and credible) BOJ stance. 
• But the massive downward revision in Japan’s Q3 GDP underscored why the Hatoyama Administration and BOJ are suddenly so cooperative, i.e., Japan is now on double dip watch as it is apparent that what was left of the prior stimulus after the DPJ finished picking through it has now worn off.
• While the mood has brightened somewhat (foreign investors were net buyers by a record JPY600 trillion-plus in the first week of December), Japan still has a large deflationary supply-demand gap as well a serious debt problem that could still come back to bite the Hatoyama Administration if it becomes clear that they will have to issue JPY53 trillion of new JGBs to fund the 2010 budget. Japan needs GDP growth of around 3% a year to halt the climb in debt as a percentage of GDP.
• Overseas, the USD appears to have the best chance in over 12 months to break its long-term decline, at least temporarily. The USD could even be the dark horse of 2010 if the Fed moves to normalize monetary policy sometime during the year.
• A USD rally however probably means a meaningful consolidation in commodity prices, which have in 2009 been more driven by excess liquidity and investor flows aimed at hedging USD weakness than real underlying demand. The best option on continued debt-financed dilution of fiat currencies is of course gold, which central banks are now buying after years of continued selling.
• While negative for commodity prices and a temporary impediment for fund flows into emerging markets, a USD rally would provide welcome relief for Japan's exporters, which are being squeezed by a combination of business unfriendly DPJ policies in Japan, ever stronger international competition from Asian rivals, and structural pressure on profit margins as demand shifts from premium US and European markets to lower-priced markets in the emerging economies.

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