China-Japan Forex Battle. While many have assessed Japan's powerful intervention (JPY 2 trillion worth of currency selling) via the lens of the US dollar, the operation could be a loud warning shot to Beijing, given the record buying of Japanese Government Bonds by China. Cynics (possibly realists) could reason that China seeks to hamper Japan's recovery by keeping the yen excessively strong, while profiting along the way (via accumulating appreciating yen and gradually reducing exposure to depreciating US dollars). After all, the race for the 2nd biggest economy remains in close contention between China and Japan. Japan's finance minister Noda has already stated "I don't know the true intention", referring to China's JPY 583 bln purchases of JGBs in July after JPY 457 bln of purchases in June. Why would the Japanese Finance Minister make such a suspicious remark? The post-intervention statements from Tokyo regarding its resolve to pursue further action sound like a warning shot to Beijing's yen-purchases as opposed to the average currency speculator.

So how will Beijing React? It could do so by tightening monetary policy via a rate HIKE and not merely -- instead of merely raising the reserve requirement after August CPI jumped to 3.5%. A PBOC tightening would have TWO OBJECTIVES; 1) address Washington's currency pressure on China. Followers of US-China currency diplomacy recall that Beijing usually responded to US FX pressures by tightening policy (either via raising rates or the reserve requirements on the basis that it is moving towards a market-based mechanism of monetary policy) rather than revaluing the currency; 2) A tightening would upset the risk trade (especially as S&P500 struggles near the 1130 resistance) and lead to fresh JPY strengthening, which would work in the favour of China's growing yen holdings.

As for the Fed, it is now operating with both hands tied behind its back evaluating whether to announce a baby-step QE2 at next week's FOMC meeting, or at the November FOMC, which coincides with the Mid-Term Election Day. While I constantly focused on the USD angle of this intervention to my twitter followers today (@alaidi) , it is important to evaluate this currency dynamic from a Japan-China perspective. You do not have to be a fan of conspiracy theories but simply an observer of economic balance of power and the pursuit of profits in a yield-thin universe.