Further yen weakness needs action, not words; foreign bond buying needed to extend currency slide

By:
Peter Garnham
Published on:

The announcement from Masaaki Shirakawa, Bank of Japan (BoJ) governor, that he will step down earlier than previously assumed has led to a renewed wave of yen weakness, but his successor will need to implement radical action for the slide in the currency to continue.

The yen’s descent in recent months has been dramatic, as the new government of prime minister Shinzo Abe has repeatedly called for a weaker yen to boost the Japanese economy and fight deflation.

The yen fell on news that Shirakawa will step down on March 19 – his term was previously due to end on April 8 – as investors brought forward expectations for a sizeable shift in BoJ monetary easing when the central bank’s new leadership is in place.

Those expectations will need to be met for the downward trend in the yen to continue, given the size of the drop already seen in the currency.

On a real trade weighted basis, the yen has weakened to its lowest levels since 2007/8, which were the cheapest levels seen in the past 20 years.

 Yen real effective exchange rate at multi-year lows
 

Furthermore, the pace of the yen’s decline has been startling.

The rise in EURJPY in the three months to the end of January was the largest in the history of the single currency. The next sharpest rise was in 2001, when EURJPY started from a record low in real terms.

The recent rise in USDJPY, meanwhile, was only exceeded in 1995 in the past 30 years, a move which started from a record low in real terms.

Top 10 three-month % changes in EURJPY since inception of the euro

Adrian Schmidt, FX strategist at Lloyds Bank Corporate Markets, notes that this time around, yen weakness has come from levels much closer to fair value.

“Though some weakness was justifiable on the basis of fundamentals, this has been the case for some time and the pace of the recent decline has been based on a lot of rhetoric from the new government, which has yet to be backed up by action, and has gone against typical yield spread relationships,” he says.

“This suggests there is a danger of a significant reversal.”

To see how the currency market is expecting a huge amount from the new government, and the next leaders of the BoJ, the yen move needs to be considered against inflation expectations.

That is because the new government believes that if it can get the market to think that Japanese deflation will end, the yen will weaken.

As Steve Barrow, head of FX strategy at standard Bank, points out, the extent to which investors are buying into that notion depends on which market you look at.

Whereas the surge in USDJPY suggests the currency market has bought into the idea, break-even inflation rates in the Japanese government bond (JGB) market seem to show a market that is sceptical.

Indeed, the rise in break-even inflation since the December 16 election in Japan has been limited, notwithstanding the lift it received when the BoJ announced a 2% inflation target in January.

“It seems that USDJPY has surged on expectations of aggressive BoJ easing – and higher inflation –while the JGB market has steadfastly refused to act with anything like the same degree of conviction or enthusiasm,” says Barrow.

“This is what makes us think that USDJPY is assuming a very bright future for the new BoJ members in terms of aggressive easing, higher inflation – and a weaker yen.”

Currency and JGB markets show different inflation expectations 
 

So does that mean the currency market is over-enthusiastic concerning the potential for action from the BoJ?

Not necessarily. After all, there is one factor that distinguishes the expectations implicit in USDJPY from those in the JGB market: the possibility of foreign bond purchases by the BoJ.

“Some prospective BoJ heads, such as ex-BoJ member [Kazumasa] Iwata, have spoken enthusiastically about this,” notes Barrow.

“BoJ applicants will have to keep talking this way – and then act in this way once appointed – in order to keep dollar/yen soaring.”

In other words, for yen weakness to continue, it is fast getting to the point at which the market will need action, not rhetoric, from policymakers.

In turn, that could open up a new chapter in the global currency war.