Buying dollar-yen: This time it could be different

By:
Peter Garnham
Published on:

Attempting to hold on to a long USDJPY position has been frustrating in recent months, as Japan’s trade position has deteriorated and tensions with China have escalated, but the time could finally be ripe for a push higher.

Attempting to hold on to a long USDJPY position has been frustrating in recent months, as Japan’s trade position has deteriorated and tensions with China have escalated, but the time could finally be ripe for a push higher.

USDJPY broke out of the ¥77-¥80 range that has held for the past six months after the dissolution of the lower house Japan’s of parliament by prime minister Yoshihiko Noda last week.

The resulting vote paves the way for former premier and Liberal Democratic Party (LDP) leader Shinzo Abe to return to power after elections on December 16. With the LDP and its allies in control of Japan’s upper house, that should leave Abe with a firm hold on power.

The yen has weakened as Abe has reiterated his view that the biggest problem Japan faces is deflation and a strong yen. He has threatened to undermine the independence of the Bank of Japan (BoJ), calling on the central bank to undertake “unlimited” monetary easing until inflation reaches a target of up to 3%.

That would require drastic action from the BoJ, considering that core inflation in Japan, which is forecast to rise to 1% in 2014, has not been higher than 2% since the early 1990s.

The key to whether the move in USDJPY is sustainable is whether or not Abe, and the BoJ, delivers.

The differential in two-year yields between US and Japanese bonds has long been a driver of USDJPY. BCA Research, for example, reckons historically Japanese investors have required a minimum of 400 basis points of additional yield as compensation to take on currency risk and recycle their excess savings into overseas assets.

With the Federal Reserve engaging in QE3, that helps explain why USDJPY has kept so close to its nominal record low, even as Japan’s economy has foundered.

According to Deutsche Bank, however, there have been instances of USDJPY deviating in recent years by up to 5% from the rate implied by US/Japan interest rate differentials, before it comes back into line.

 USDJPY deviations from 2-year rate differential

 
 Source: Deutsche Bank, Bloomberg

Bilal Hafeez, head of FX strategy at Deutsche Bank, says that suggests a move to ¥82 or ¥83 in USDJPY is possible without a supporting move in rate differentials.

“This matches our year-end target of ¥82,” he says. “However, for a larger move in USDJPY we would need to see the LDP deliver on its promise of reflationary policy – or US yields to go up.”

So will they deliver?

UBS says the fact that the five-year term of Masaaki Shirakawa as BoJ governor ends on April 8 makes USDJPY a buy on dips.

The bank says that as Japan’s prime minister gets to nominate Shirakawa’s replacement, and that both houses of parliament have to approve the new governor, Abe will be in a strong position to place a more dovish head at the central bank.

UBS points out that since the BoJ became independent of the ministry of finance in the late 1990s, the central bank’s three governors – Masaru Hayami, Toshihiko Fukui and Shirakawa – have all been conservative policymakers drawn from the central bank’s staff.

In contrast, the candidates in the running to be the next BoJ governor – former administrative vice-finance ministers Toshiro Muto and Eijiro Katsu, former vice-finance minister for international affairs Haruhiko Kuroda, former economics minister Heizo Takenaka, and former BoJ deputy governor and academic Kazumasa Iwata – have all made their careers outside the central bank.

“As a result, they are all likely to take a substantially more dovish approach to monetary policy,” argues Mansoor Mohi-uddin, global head of FX strategy at UBS.

He says investors should therefore expect USDJPY to start trending higher now in anticipation of a new BoJ governor next year, while this week’s BoJ meeting, which is unlikely to result in any new easing, could provide USDJPY bulls with a better entry level.

“But if the central bank does follow through with more aggressive easing after April under a new governor, USDJPY will trade well above our ¥85 three-month target,” says Mohi-uddin.

Political interference at the BoJ is set to become a substantial negative for the yen.