USD/JPY: Domino Theory

Now that the UK referendum has been resolved what does that mean for USD/JPY, in particular, does the Asia-Pacific economic region have enough problems of its own to be significantly impacted by any events in the west? At the most recent 16 June BOJ meeting, it was noted that, first the BOJ would maintain all dimensions of monetary policy; continue to expand the monthly monetary base through market operations. This would include the purchase of JGB, ETF, Japanese REITS and corporate bonds. Lastly, the BOJ indicated the continuance of the negative reserve deposit rate of -0.1%.

As far as its view on the economy, the BOJ noted that “...exports and production have been sluggish due mainly to the effects of the slowdown in emerging economies... ...the pace of growth has somewhat decelerated mainly in emerging economies... ...the pick-up in exports has paused...” It’s safe to assume that the BOJ was not referring to Europe, but rather South America and the Asia-Pacific where it maintains substantial fix capital investments and where capital flow is heaviest.  However, the most important variable in the Japanese economy is the unclear situation of the Chinese economy; its top trade partner.

In its 2015 annual report the People’s Bank of China noted that the economy still faced large downward pressure. The bank pledged prudent monetary policy and that additional industrial capacity would be strictly controlled and that the inflation outlook remains uncertain. Interestingly, it was reported by the Russian News agency Tass, that Deputy Finance Minister Maxim Oreshkin expressed concern over the impact of a possible recession in China: “...The risk is in place that attitude of financial markets and investors towards China, including the real sector of the economy, may enter a negative spiral. If the situation proceeds under such scenario, we may even see the recession in China. This scenario is so painful that we cannot neglect it. The crisis in China and its immediate spread in the Southeast Asia may be even more severe from the standpoint of global economic growth than the world’s financial crisis...” Deputy Minister Oreshkin was quick to note that the probability of such an event was low, in the 5% to 10% range. However, has that probability now increased in the wake of the UK referendum?

This view is not the only view and most are in opposition. For example, a recent Thomson Reuters/INSEAD survey indicated that the Chinese economy was “slowly steadying”, with corporate sentiment near a one year high. According to INSEAD Business School Economist Antonio Fatas, “...What we are seeing today relative to the past two quarters is that Chinese risk has gone down. People are a little bit less worried about the possibility that something sudden will happen in China...” The survey indicated that sentiment improved around the region, with the exception of Japan, where the index showed a 31 point decline to an all-time survey low.

The point is that a combination of a lack of clarity plus diverging opinions from respected sources and surveys along with a very negative business sentiment in the region’s dominant economy may explain why the Yen remains persistently strong in spite of BOJ efforts to weaken it. Now that the Brexit vote has at the very least created more uncertainty in the western economic sphere, must the BOJ act sooner? It should be noted that the Yen strengthened significantly against the US Dollar after the UK referendum result was certain. Clearly, traders in the Asia-Pacific region see the Brexit as a threat, not directly to Japan, but likely to its main trading partner, the PRC, thus indirectly weighing on the Japanese economy.

On the other side of the equation, the US Federal Open Market Committee has throttled back on its planned four 2016 Fed Funds rate increases. The change in sentiment began with a surprisingly weak job creation report as well as other data which did not indicate accelerating growth. The Fed seemed to indicate that growth was not expanding at a previously expected pace. In the semiannual report to congress, Chair Yellen noted the possible change in momentum as well as continued low inflation: “...All told, the latest readings suggest that labor markets are tighter than they were at the end of last year but that the pace of improvement has slowed. Whether those signs of slowing will be confirmed by subsequent data, and how persistent any such slowing will be, remains to be seen... ...some survey-based measures of longer-run inflation expectations have remained relatively stable, while others have moved down; market-based measures of inflation compensation also are at low levels...”

Inflation compensation refers to the premium primary dealers are willing to pay for inflation compensated principal bonds vs those without inflation compensation.  The statement went on to note that “...One area of concern, however, is the softening in business fixed investment in recent quarters even beyond those sectors most directly affected by the plunge in energy prices. In addition, the weakness of exports--following the significant appreciation of the dollar over the past two years and the subdued pace of foreign economic growth--continues to hold back overall output growth...”  Indeed, several days after her testimony and just hours after the UK referendum vote, a key US economic indicator, Durable Goods Sales, badly missed expectations and the previous month was revised downward.

Lastly, the statement from the introductory remarks of the congressional testimony reiterated what was noted in the 15 June monetary policy statement: “...The Committee expects that economic conditions will evolve in a manner that will warrant only gradual future increases in the federal funds rate, and that the federal funds rate will likely remain, for some time, below levels that are expected to prevail in the longer run...” 

What it all seems to add up to is that the Fed had already decided to wait until the economic data indicated a definitive positive growth trajectory. Further, although the Brexit referendum has now been decided, it still might take some time for Europe to readjust to the decision. This will likely cause the Fed to be even more patient.

The point is that the BOJ may not get any help from a stronger US Dollar and consequently, must rely on its own actions if it hopes to drive down the Yen with policy tools. In particular, it’s difficult to see significantly weakening Yen vs the US Dollar even with BOJ measured actions. Lastly, the likelihood of a Fed rolling back the December 25 basis point increase should not be discounted.