Stage Set For 125 in USDJPY?

A number of factors have combined to set the stage for a new period of strength in USDJPY. Rising global bond yields are created scope for the BOJ’s yield curve management focus to achieve its greatest effect. The BOJ can comfortably target all of its JPY80 trln QE operations on the long end of the JGBs, keeping bond yields at or near desired levels.

Although the steepness of the nominal JGB yield curve has remained moderate, the volatility adjusted curve has now sufficiently steepened to allow local financial institutions to shift funds into the positive yield portion of the JGB yield curve. This is particularly important for Japanese banks which hold around 16% of their total assets in shorter-dated JGBs. Simultaneously, Japan’s yield curve should stay flat compared to other G10 yield curves, thus ensuring a tide of JPY denominated funds moving abroad and pushing JPY lower.

JPY’s Relationship With Inflation Expectations

JPY typically trades inversely to global inflation expectations which makes sense given the reduced ability of Japan’s nominal yields to react to a sharp deflationary shock. Japan’s real yields have transitioned to become almost entirely a function of the global inflation outlook.  As global inflation expectations have started to move higher, Japan’s real yields have started to move lower.  Outside of the domestic environment rising inflation expectations have driven nominal yield curves higher resulting in real yield differentials that encourage most currencies to strengthen against JPY. Given the global yield environment, the shifting of the BOJs focus away from short term interest rates and on to yield curve management could not have been timed better.

BOJ Yield Curve Management

The BOJ’s yield curve management focus has not only capped JGB yields below the 10Y maturity but has also applied a slope. Should JGB yields begin to rise as a consequence of the rise in global bond yields then the BOJ can buy an unlimited amount through expanding its balance sheet.  In contrast to this, yields in the US are higher and vulnerable to further increases, widening the yield differential with Japan and thus further supporting USDJPY. 

The US side of the equation also supports further upside in USDJPY. With the US growth and inflation outlook having risen in the wake of President Trump’s election, there is upside risk that the Fed hike at a more aggressive pace over 2017 than markets are currently expecting which will again increase the yield differential between the two countries.

US & Japanese Fiscal Policy

In terms of fiscal policy both the US and Japan are expected to expand government spending over 2017 which should bolster risk appetite and could thus fuel an increase in Japanese spending abroad.  If the Japanese government does choose to increase its debt issuance to fund its increased fiscal spending, then the consequent rise in inflation expectations would also weigh on JPY.

FX Hedging Needs

As USDJPY strengthens, there is a deterioration in the need to FX hedge foreign investments again increases the scope for upside. In the first quarter of 2016 Japanese investors began hedging more foreign assets, providing JPY strength. As USDJPY moves higher, these hedging ratios might change. The market is still net long JPY, as this bias shifts, further upside is in store for USDJPY.

Japan’s inflation increasing faster than the rate of nominal yields, which are capped by the BOJ, should weigh on real yields. Real yield differentials imply that USDJPY should currently be trading above current market price. US yields are expected to rise whilst real yields remain fairly muted – this should encourage Japanese banks to lend more and take on more risk as they see a predictable yield curve. The result should support USDJPY eitherway with foreign lending weakening JPY and domestic lending fuelling an increase in inflation expectations.

The main risk to this USDJPY upside view is if global risk appetite should suddenly deteriorate as a consequence of increased global growth worries which would put significant downward pressure on equities causing Japanese investors to repatriate foreign investments which would strengthen JPY.

For now, USDJPY is sitting between key resistance at the 115.50 level (broken prior lows from the head & shoulders pattern, 61.8% retracement from 2015 highs) and key support at the 107.50 level (broken bearish trend line & broken prior highs). A sustained breach of the 115.50 resistance should pave the way for a retest of last year’s highs.