Something interesting in Japan - Deutsche Bank

"Something interesting is going on in Japan. Having tracked the yen very closely over the last ten years Japanese equities are surging higher even as USD/JPY has stayed weak," points out Deutsche Bank strategits George Saravelos.

Key quotes:

"It looks like a regime shift is taking place. What is driving this and can it tell us something about the future?"

"To start with it is useful to recognize that correlation breakdowns are important in FX. Acknowledging the regime shift in the FX-rates relationship was important in making us more bullish EUR/USD earlier this year for instance. What is going on in Japan? Our first observation is that the direction of causality has historically run from the yen to stock prices: a higher USD/JPY drives stocks via rising earnings expectations rather than vice versa. In contrast, big yen moves have coincided with the broad dollar trend which the Nikkei is too small to influence. Our second observation is that foreign buying of Japanese stocks has recently jumped to nearly a record high. There is a wave of idiosyncratic demand emerging for Japanese stocks irrespective of where the yen is going. The global equity market rally may be “crowding in” foreign investors given that the Nikkei remains very cheap on many standard P/E metrics."

"What does all of this mean for FX? At face value one can argue that the regime break is only relevant to equities given that the yen continues to track the dollar trend quite well. This conclusion may be premature. First, the breakdown in the FX-equity relationship suggests that there is no longer any incentive for foreign investors to hedge their purchases of Japan stocks. The marginal flow story for the yen may therefore be becoming more supportive. Second, the breakdown in the equity-FX relationship is another warning shot that FX drivers are not stable. One of the strongest views in the market is that US yields will remain the most important driver of USD/JPY going forward. This may well be the case into year-end (we have a bullish USD/JPY end-17 forecast), but the relationship has been very weak over the medium term."

"Consider a scenario where Japan equity flows keep rising or the BoJ takes a hawkish turn next year. Either of these would support the currency irrespective of what is going on to US yields. Alternatively consider the scenario of a Trump appointment to the Fed chair that leads the central bank on an extended pause to defend the bank's inflation-targetting credentials. This is an environment where back-end yields would rise on higher inflation expectations but the dollar would most likely weaken. Rising long-end yields but material dollar weakness was exactly what happened in 1994-95 (chart 5). With the correlation between USD/JPY and US 10-year yields close to record highs (chart 6), hybrid derivative trades that look to benefit from a combination of higher US yields but a weaker USD/ JPY next year offer exceptionally good value."