Japan's economy contracted sharply in the second quarter

Japan's economy contracted sharply in the second quarter after a sales-tax increase in April sent household spending tumbling and the real GDP, shrank 6.8%. Prime Minister Abe and other policy makers have said they expect the downturn to be short-lived. However, if things go different from their forecast, is there a chance of more economic-stimulus measures in the foreseeable future?

We believe that the Bank of Japan will respond to further data undershoot from here, especially once we get through more Q3 figures, which will be less impacted by the April sales tax hike. Citi’s baseline is for an additional QE programme towards the end of October.

Regarding the falling number for Japan’s export - some economists say that Europe and U.S. are not that strong, other theories mention that there are some structural problems in Japan, in which it does not respond to the Yen weakness the way it used to. What to your mind is actually happening with exports in Japan?

Citi economists see this as driven by a culmination of factors. Primarily, they note slower growth amongst major trading partners in the first half. Moreover, they indicate longer term trends toward increased production by manufacturers’ overseas and declining competitiveness of the Japanese technical industry. While everyone anticipates exports to recover over the near term, the recovery is likely to be modest.

What will be the major headwinds for the JPY until the end of this year?

We expect a couple of factors to weigh on the JPY from here. Firstly, divergent monetary policy should continue to be a positive driver for the USD/JPY. We look for an exit from the Fed’s Quantitative Easing programme in October, alongside with a stepping up of the BoJ asset purchases with domestic data undershooting initial estimates. Boosting JGB and ETF purchases further, we expect the JPY to underperform. Secondly, we anticipate asset flows to be negative for the Yen. With government pension reform expected toward the end of the year, the GPIF is anticipated to cut domestic bond holdings in favour of domestic equities and foreign assets. Hence, this as much could lead outperformance of both Japanese equities, as well as weakening of the JPY.

What are your forecasts for the USD/JPY, EUR/JPY and AUD/JPY by the end of Q3 and the end of 2014?

Our short-term forecast for the USD/JPY currency pair is 102 and we anticipate seeing the pair at 108 by the year end. Talking about the AUD/JPY, our forecast for the Q3 is 96 and 102 for the long-term perspective. Finally, in the third quarter we look for 138 for the EUR/JPY in the short-term and 143 for the end of this year.