Will Signs of Japanese Deflation Keep Carry Trades on Track?

[B]National CPI (YoY) (MAY) (23:30 GMT; 19:30 EST)[/B]
[B]National CPI Core (YoY) (MAY) (23:30 GMT; 19:30 EST)[/B]
[B]Expected: -0.1%[/B]
[B]Expected: -0.3%[/B]
[B]Previous: 0.0%[/B]
[B]Previous: -0.2%[/B]

[B]How Will The Markets React?[/B]
Economic news out of Japan has been dour over the past 24 hours: last night, industrial production unexpectedly plunged for the third consecutive month by 0.4 percent during May, led by a 2.7 percent slide in manufacturing of electronic parts and devices - the biggest drop since October 2004. Prior to that, the Business Sentiment Index for large manufacturers in the second quarter slipped to a reading of -2.2 from 0.1. On the other hand, retail sales have started to pick up and personal consumption growth made a positive contribution to GDP for the second quarter in a row. Notice a trend? The Bank of Japan is likely to, as one of the major lynchpins of economic growth in the country is starting to falter as demand from the US slows. However, Hiroko Ota, the Economic and Fiscal Policy Minister, acknowledged yesterday that there is “some weakness” in production, but maintained that economic growth overall is “solid” while Bank of Japan Governor Toshihiko Fukui said the central bank aims to adjust interest rates gradually. Does this mean rate normalization is in the cards? It is very doubtful, at least until after the LDP elections in July, since both headline and core National CPI are anticipated to fall further into deflation. It is absolutely essential for price growth to return to positive territory before the Bank of Japan can even consider raising interest rates without crippling the economy, especially amidst signs that the manufacturing sector is starting to falter. As a result, traders will likely pay heed to any further deterioration and assume risk-taking market positions in order to take advantage of profitable carry trades.
[B]Bonds - 10-Year Japanese Government Bond Futures[/B]
The slow and steady ascent of 10-year JGB?s has officially collapsed for the short term, as Fibonacci resistance at 132.00 proved too powerful for bonds. However, the next trading session may prove hazardous with major event risk on tap: the release of Japanese inflation figures. Both headline and core National CPI are anticipated to fall back further, signaling that deflation is alive and well and also eliminating any opportunity for rate normalization by the Bank of Japan. As a result, JGB?s could target 132.00 once again, but mild gains in CPI - even if it is still negative - could do the exact opposite and lead prices down towards 131.30.

Though we saw a bout of Japanese yen strength lead NZD/JPY to back off from 20 year highs of 95.20, the pair has started to target the level once again as carry trades dominate the market. Strong trends such as these cannot be ignored and can prove difficult to fade, but there?s no such thing as a one way bet, especially in the FX markets, thus we turn to the major event risk due out of Japan at 19:30 EST tonight. Both headline and core National CPI are anticipated to ease further into deflation, essentially eliminating the chances of any policy action by the Bank of Japan in the near-term. Such news would only inflame the sentiment that carry trades remain in tact since there is little reason for the Japanese yen to rally significantly. As a result, NZD/JPY is very likely to challenge the recent highs once again. On the off chance that Japanese CPI actually rises into positive territory, however, the Japanese yen may see a brief burst of strength, but a full out carry trade unwind is highly unlikely as NZDJPY would soon find support near 93.00.

[B]Equities - Nikkei 225 Index[/B]
Japanese stocks rebounded after a three-day slide, sending the Nikkei 225 Stock Average up 0.5 percent to 17,932.27 at the close of trading in Tokyo. Honda Motor Co. jumped the most in more than two weeks by 2.1 percent 4,420 after the yen reversed a strengthening trend and two brokerages issued bullish reports on the country’s automakers, citing benefits from the weak currency. Other exporters benefited as well, as Nissan Motor Co. added 1.4 percent to 1,301 and Nintendo Co., the world’s biggest handheld game maker, advanced 2.2 percent to 45,050.
After hitting resistance at the 18,300 level, the Nikkei 225 looks like its ready to resume its uptrend. However, major Japanese event risk looms on the horizon as inflation reports are scheduled for 19:30 EST. The National headline and core CPI readings are both anticipated to soften in the month of May on an annual basis to -0.1 percent and -0.3 percent, respectively. With prices still signaling mild deflation, there is almost no chance that the Bank of Japan would take any steps towards rate normalization. As a result, Japanese equity market bulls may take the news and run with it, pushing the Nikkei 225 to 18,000.