The Yen has been strong so far in 2014

Esther Maria Reichelt, FX Strategist, on the Japan’s economy and JPY

The Most of the market analysts believe that Japan’s economy contracted in Q2; however, the focus is on whether growth will pick up in Q3 for Abe to proceed with a further increase in consumption levy. Do you think Japan’s economy will be strong enough in Q3 to not raise the odds of fiscal or monetary support in the coming months?

To my mind, further monetary support, which will ultimately result in a weaker Yen, can be triggered by two factors. First of all, if the economy does not recover from the setback in demand due to the sales tax hike, and second, if the Bank of Japan's inflation target is in danger of not reaching 2% in 2015. The first data for May and June indicated that contraction following the VAT hike was indeed temporary. In case the slow recovery continues, we assume that there will not be any further direct fiscal and/or monetary support for the economy. However, right now we do expect the ongoing monetary easing later this year, which will result in a considerably weaker Yen by the end of 2014. The reason for this is that we do not anticipate the prices to increase later this year.

The Yen has been strong so far in 2014; energy prices are likely to contribute less to the overall inflation, as nuclear power will gradually be reinstated. Moreover, base wages have not increased so far – all of this speaking for a very subdued underlying inflation pressure. However, without increasing base wages it is unlikely that inflation will be generated due to demand-pull effects. Thus, we assume that Japan's economy will be robust enough not to require any further fiscal or monetary support, but not strong enough to trigger inflation, which will again increase the odds for further monetary easing.

The overall inflation in the country was at 3.7% with electricity charges up 11.4% and gasoline up 9.6% year-on-year; at the same time, wages excluding overtime payments and bonuses fell for the 23rd month in April. In this situation it is hard to imagine households willing to spend; therefore, do you think that Abe has been taking the right steps for a successful recovery?

I believe that the most important thing is to trigger inflation, and a successful recovery will quite likely be to achieve increasing wages. At the first glance, the general approach with corporate-friendly reforms targeting an increased competitiveness is correct. However, so far Prime Minister Shinzo Abe is lacking effective reform plans. In particular, so far he has refrained from tackling the problems in the extremely inflexible Japanese labor market. Moreover, the necessary reforms of the labor market and social security system have been held off for too long. Hence, the right steps for a successful recovery have not been announced so far.

At the moment the Yen is climbing as tensions in Iraq and Ukraine are spurring demand for safe haven assets. However, what to your mind will be the most important drivers for the currency through the Q3?

In case it becomes evident that the price target of the Bank of Japan is endangered, the market is likely to price in further expansionary measures by the BoJ again. To my mind, there is actually an interesting dynamic: if the recovery is more robust, the Yen is stronger, as markets price out further monetary easing. But a stronger Yen increases the chance for further easing, as most of the inflation seen so far is likely to be due to the depreciation of the JPY until the end of 2013. On the other hand, the Yen remains a safe haven currency and will be affected by the global risk sentiment.

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

We expect the USD/JPY to trade at 104 by the end of the third quarter and our forecast for the end of this year is 110 for the currency pair. For the EUR/JPY we anticipate 141 level for the end of Q3 and 147 for the end of 2014.