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Foreign Exchange

Markets underestimate BoJ; USDJPY set to test higher

USDJPY, after acting like a pegged currency since August, has sparked into life as a combination of aggressive easing from the Bank of Japan, improving risk appetite and concerns over the Japanese economy have dented demand for the yen. The signs are that USDJPY has finally found a bottom, writes Peter Garnham.

USDJPY has risen nearly 5% since threatening to hit a record low earlier this month and is now trading at its highest level since July. Betting on gains in USDJPY has been an easy way to lose money in recent years, so has anything really changed, and will the currency push back towards its highs after a shake-out of speculative long yen positions?

Certainly, short-term positioning seems to have taken its toll. As EuromoneyFXNews reported at the start of the week, speculators on the IMM engaged in their largest bout of yen selling since November in the week to February 14, halving their long positions in the currency.

Judging by the price action since then, that position squaring has continued.

However, there are other factors at work – the main trigger for the reversal of fortune in the yen appears to have been the Bank of Japan’s surprise decision to expand its asset purchase programme by ¥10 trillion and introduce a new 1% inflation target.

News of a widening Japanese trade deficit in January hardly helped the yen’s cause, but worries that the country will soon have a persistent current account deficit look overdone. The January trade figure was partly down to seasonal patterns and the relatively early timing of Chinese New Year, and Japan still has a large income surplus to counter any trade shortfall.

The game-changer, therefore, was the BoJ’s decision to increase its purchases of Japanese government bonds (JGBs) with maturities of one to two years, which has the potential to cap yields even as global economic data improves. This has the potential to drive the yield differentials higher between two-year Treasuries and two-year JGBs, which has been a key determinant of USDJPY levels.

 US-Japan 2-year yield differential & USDJPY

 
 Source: Nomura, Bloomberg

Analysts have rushed to raise their forecasts for USDJPY.

Jens Nordvig, head of FX strategy at Nomura, for example, raised his forecast for USDJPY from ¥76 to ¥79, adding that as well as the action from the BoJ, the recent rebound in global risk appetite, in part triggered by the European Central Bank’s (ECB) LTRO, would also weigh on haven demand for JGBs and weigh on the yen.

There is also a flip side to this, with the rebound in risk appetite also encouraging risk appetite among yield-hungry Japanese investors and encouraging them to send funds abroad.

Indeed, it is no coincidence that Daiwa’s Short-Term Australian Dollar Bond Open Fund – which does what it says on the tin – is set to become Japan’s, and Asia’s, largest mutual fund.

It is likely that Japanese demand for Toshin – which allow investors exposure to foreign currency assets – will increase as risk appetite improves.

This market segment was a big contributor to yen weakness between 2005 and 2007, but, as can be seen in the chart below, Toshin demand for FX products tailed off in 2008 and 2011 as global asset markets tumbled and home markets were favoured.

 Japanese investment trust buying of FX assets

 
 Source: MoF, Japan

The problem with buying USDJPY is the Federal Reserve’s assertion that its economic forecasts are consistent with very low Fed-funds rates until at least 2014.

However, it would seem that, rather like the initial scepticism towards the ECB’s LTRO, markets are underestimating the BoJ’s ability to move the currency market.

UBS, which has raised its target for USDJPY to ¥85 from ¥80 by the end of the year and to ¥90 from ¥85 by the end of 2013, say it would be dangerous to assume that the BoJ has exhausted its options, and that investors should be braced for further action that will embolden yen bears.

The key to this is the political heat on the BoJ from the country’s ministry of finance, which would prefer not to engage in further currency intervention, given that it would not go down well with its G7 partners and would reflect badly on Tokyo as it tries to promote free trade through trilateral talks with China and South Korea.

The upshot is that the BoJ is likely to keep rates lower for longer than the US, and that finally it is time to go long USDJPY.

pgarnham@euromoney.com

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