The Japanese economy unexpectedly shrinks in Q3, may force Tokyo's hand

The Japanese economy unexpectedly shrank last quarter as a hike in the sales tax in Q2 continued to weigh on economic activity. As we have stated on numerous occasions, the lack of activity at the ground level in Japan and the failure of a weakening yen to significantly boost exports is killing economic activity. The yen initially weakened on the back of Japan’s all-important GDP figures as the Nikkei rallied, before Japanese equities began to fall and the yen reversed its course. The numbers were so bad as to spook the market sufficiently to result in the aforementioned sell-off in equities.

GDP fell a seasonally adjusted 0.5% q/q and an annualised 1.6% q/q in Q3, missing expected increases of 0.5% and 2.2% respectively. The numbers show that the hike of the VAT in April is having a far more detrimental impact on the economy that initially expected, thus it should be enough evidence to persuade Tokyo to delay increasing the sales tax for a second time.

Last week we postulated that Prime Minister Abe may officially push back an expected hike in the VAT by 18 months if today’s data was significantly worse than expected. This was supported by rumours from the Japanese media and some cryptic comments from law makers. After today’s very disappointing numbers, we are almost certain that Abe will announce in the coming days that the planned October increase in the VAT will be postponed by at least six months.

The market reaction

The initial sell-off in the yen is a likely reaction to significantly worse than expected economic data. After all, weak economic data of this magnitude pushes any central bank to be more dovish than it otherwise may be. However, the BoJ is already engaged in mass easing and it’s unclear what else the bank can do expect wait and see what affect this has on growth. Furthermore, the possibility of a delay in the next VAT hike may take some pressure of the BoJ to ease further in the future and the interlinked relationship of the Nikkei and the yen complicates the market’s ability to effectively price this new data into both asset classes.

From a purely logical standpoint, one may expect both the Nikkei and the yen to fall on the back of such a data misses. Yet, a weakening yen is generally a positive for stocks and vice versa. The end result is that the inability of the BoJ to ease further, which would typically weaken the yen, is combining with negative investor sentiment to drag down the Nikkei and, in turn, push the yen higher.