Japan's economy grew less than initially thought in the final quarter of 2014

Jonathan Cavenagh, Currency Strategist at Westpac, on Japan’s economy and Yen

Japan’s economy grew less than initially thought in the final quarter of 2014, revealing an even weaker emergence from recession than previously believed. The poor data could put the Bank of Japan under pressure to launch more stimulus, as the world’s third largest economy struggles to rid itself of two decades of lassitude. Do you anticipate that the BoJ will raise rates and if yes, when it is more likely to happen?

I believe Japanese interest rates increase is still a very long time away. The big question remains whether there will be a sustainable recovery in Japan. Not so long ago there was speculation the BoJ may have to do more stimulus. The Central Bank is pushing back, saying they want to see the impact of the much recent stimulus in October of last year. Officials want to check what the impact is around the middle of this year to Q3. Thus, we are going to get a better sense whether the Japan’s economy is travelling relative to expectations.

However, we have the other issue of consumer spending, which is quite weak in Japan. Inflation has definitely developed, but it could be hard work getting it improved even more. Going forward, there is still a lot of work to be done under reform fund from a domestic perspective in Japan. It puts the economy on a sustainable and stronger trajectory, but it is difficult to envisage the Yen currency strengthening a great deal from here.

Prime Minister Abe said that falling oil prices are positive for the country's economy, as they boost corporate revenues and households' disposable income. However, slumping oil prices have nudged annual core consumer inflation to 0.2% in January, pushing it further away from the BoJ's 2% target. Do you agree that the Japan’s economy in fact is benefiting from the low oil prices?

I believe it will benefit, but probably in a longer run, since the Minister said Japan is obviously net oil importer across a lot of commodities. Thus, weaker commodity prices should definitely see into the stronger terms of trade stories for Japan. We suppose they will be boosting corporate margins, which is definitely something positive from that perspective.

I guess the critical question is how much of the oil prices decline is indicative of supply side or demand side factors. If it is demand side shock, there is a risk that Japan does not get a great deal of fall through benefit. Falling oil prices are calming down because the global crude demand is weaker than Japan’s. Thus, probably they are going export less than what it has over the past 12 months. However, if it is supply side shock, as we tend to think it is, we will definitely come through more of a positive situation.

Nevertheless, at the moment the main issue is a deflationary force, rather than one that is positive for the growth. It could really turn into a positive factor for the Japanese economy if they get their part of the story right with the structural reform. Yet, we see stronger growth in China and Europe combined with the already strong growth in US. Presently we are just dealing with the deflationary impulse and its impact on inflation, which in fact does not show to be positive for demand at the stage.

What will be the major headwinds for Yen throughout Q2 2015 and in the long term and what are your forecasts for USD/JPY and EUR/JPY for the same period?

I guess the major headwind is not going to come from Japan itself, but probably more outside of country. Thus, we believe the major issue is the prospect of higher interest rate in US. That should keep the USD/JPY in deeps and quite well support it. We see the USD/JPY rising towards 1.22 by the middle of this year and then 1.26 by the end of this year.

We generally have the Dollar strengthening against the Yen, because we suppose the BoJ is very much maintaining quite an impressive stimulus and expanding its balance sheet. At the same time, we have higher rates in the US, and there is every chance for the USD/JPY to go higher. In the near term it will probably trade at 1.20-1.22 range, meanwhile, any deeps below 1.20 levels are going to be very well supported by the market.

I do not really expect the EUR/JPY to do a lot in the near term. I believe the currency pair will probably weaken a little bit further from here. We are currently about 1.27 levels, and I anticipate the pair to go down to 1.25 for the next two months before we start stabilizing. Thus, we probably will be at 1.22-1.27 range between now and the end of the year, since there is enough bad news that impacts the Euro outlook, such as the recent launch of ECB’s QE programme.