Attempting to hold on to a long USDJPY position has been frustrating in recent months, as Japans 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 Japans 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 Japans 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 Japans 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|
Political interference at the BoJ is set to become a substantial negative for the yen.