JPY reversal key for global markets

Posted on July 12th, 2016

The rebound in USD/JPY this week could be a key development for global markets. It could signal a shift in sentiment that has driven global bond yields and break-even inflation expectations to record lows. 


A confusing year for markets made worse by a rebound in JPY

Global financial markets have been confusing this year, lacking clear themes and often seeming at odds with historical relationships.  There has been evidence of high risk aversion, such as a strong JPY, record lows in global bond yields, a deep fall in GBP and weaker EUR/CHF and EUR/DKK.  But there has also been evidence of improving risk appetite, such as stronger commodity prices since January. And emerging market currencies and equities have generally out-performed developed market equities and most developed market currencies; including the EUR and USD.

It appears that extreme low government bond yields have forced investors into riskier assets including equities, corporate and emerging market bonds and currencies, even though confidence in global growth has ebbed and fears for global market stability have increased.

Part of this process has been more proactive central bank policy generating downward pressure on global bond yields.  While this may have supported riskier assets it has failed thus far to raise global growth and inflation expectations.

As such, some investors have become worried that monetary policy has run out of scope to further drive growth and inflation higher, turning the conversation to what next – including the need for faster structural reform, fiscal spending, and fashionable calls for something called helicopter money, which may have several meanings in practice, but broadly refers to a central bank financing fiscal expansion.

A significant contributor, in our view, to the unusual state of markets, where yields have plumbed new depths has been the remarkable strength in the JPY this year, and to a lesser extent the firm EUR, in the face of further rate cuts into negative territory.

The market had begun to fear that Japan in particular could not escape deflation. Its already aggressive monetary policy actions were failing and negative rates may have even been counter-productive; undermining bank profitability, and weakening consumer and broader economic confidence.

As such, we look on the bounce in the USD/JPY this week with extreme interest.

The rise in USD/JPY since the strong result in the Upper House election for the ruling LDP led by PM Abe and its coalition partner the Komeito Party may be a significant boost for global confidence.  It may help turn from down to up the trend in global yields and breakeven inflation expectations, from their recent record lows.


Predicting JPY is a strange alchemy

The JPY has had a life of its own this year. The extent of the powerful down-trend in USD/JPY cannot easily be justified, and equally the rebound underway this week seems a little bizarre.

The elements that might explain a rebound in USD/JPY include the prospect of a larger more decisive fiscal spending package, opening the door for a more purposeful expansion of BoJ QE bond purchases.  It might fit the description given to so-called helicopter money that some have advocated or predicted could be the next more powerful iteration of monetary policy easing (monetizing fiscal expansion).

But if you buy into this argument for a falling JPY, how do you explain the rapid rise in JPY in May/June even though the Abe government was widely expected to announce fiscal expansion. And most analysts predicted the BoJ would follow suit with more QE.  The USD/JPY dropped sharply on a well-heralded announcement by Abe on 1 June that he would delay again the next increase in the sales tax.  This announcement increased the odds of more fiscal spending and some analysts then thought this was the reason for a stronger JPY.

So now it confounds reasoning to use the same essential facts to explain a sharp fall in the JPY.  All this goes to show that predicting currencies, especially the JPY, on fundamental analysis is a strange alchemy indeed.


Time may be ripe for a change in sentiment

I tend toward thinking that more fiscal expansion, combined with more BoJ QE, should weaken the JPY, and thus fundamentally I can get behind the fall in JPY this week.

However, after being on the wrong side of a rising JPY on a couple of occasions this year, I had come to the conclusion that the down-trend in USD/JPY was powerful and to be respected, almost regardless of whether the Government might expand fiscal policy or if the BoJ might further ease policy.

Indeed this strong trend in JPY had tilted me towards expecting a deep fall in global bond yields that would confuse and sap global investor confidence, drive the gold price higher and tend to drag down the USD more generally in topsy turvey but rising EM markets and global equities.

The rising JPY had more to do, I believe, with a medium term position adjustment than any major fundamental shift, although there were several contributing factors.  These included:

  • (1) A slowing in the US economy during 2015 and into 2016 in part related to the stronger USD in 2014/2015 and weak energy sector, delaying the progress towards higher US interest rates;
  • (2) G7/G20 agreements not to pursue competitive currency devaluations, confusing the message to the market on what negative interest rate policies were meant to achieve;
  • (3) Weaker growth and greater financial uncertainty in China, undermining confidence in emerging market growth, and weakening the outlook for investment abroad for Japanese investors;
  • (4) Intense hand-wringing from all and sundry over the possible negative global repercussions from Brexit that have probably been exaggerated for political reasons;
  • (5) Falling confidence in the Abe government and the BoJ to pursue structural reform and the 2% inflation target at all costs.

The positioning/sentiment argument for a stronger JPY was the shock many global and domestic investors felt when USD/JPY broke through the lows last year around 115, and the failure of USD/JPY to rise after negative rates were introduced in a surprise move in late-Jan.

The outflow from Japan’s pension industry, led by the GPIF in 2014 and 2015 was probably also largely complete and lower energy prices helped contribute to a larger current account surplus.

As such, The flow of funds and the chart technicals became more supportive for the JPY.  In fact most analysts started calling for a strong JPY to persist and traders switched to significant long JPY positions.  Many longer term investors that were positioned for a weaker JPY based on diverging monetary policies and faith in Abe and Kuroda to do whatever it takes to drive up inflation, were forced to re-evaluate and cut these positions.

However, after a 20% rebound in JPY from its lows last year, it may have become over-extended and ripe for reversal.  We may be now see a sustained trend turn towards a weaker JPY as the market considers:

  • (1) The fundamental pressure from negative rates;
  • (2) The prospect of combined fiscal and additional monetary policy easing and an Abe led government rejuvenated by a decisive election win;
  • (3) A reassessment of the state of the US economy after a strong payrolls report;
  • (4) Less fear over the outlook for global markets with the Brexit referendum out of the way,
  • (5) Political uncertainty in the UK and to some extent the Eurozone reduced.

It may not be a complete reversal of the rise in JPY over the last year, but it is possible that a good deal of this rise in JPY was an over-kill and a significant reversal in these gains may be underway, provided of course that Abe and the BoJ deliver.

Abe has said since the weekend that he will pursue fiscal expansion and structural reform, and many hope that he will not be side-tracked by his ambition to change Japan’s pacifist constitution and use his super-majority support in parliament to bring on a referendum.

New announcements on a big fiscal package are expected in the fall sessions of the diet (August).  A question the market will now ponder is whether the BoJ may pre-empt this step with more QE on 29-July; presumably by then the discussion over the size and scope of fiscal spending will be taking shape.

If anything, we should have learned this year to beware of perverse market developments that may contradict conventional wisdom.  A genuine risk is that a turn in sentiment on the JPY is a trigger for a global rise in bond yields from record lows, including JGBs, even though we seem on the crux of more policy easing from the BoE and BoJ.

At this point the extreme lows in yields are at risk of turning up because a fall in JPY could help raise confidence in Japanese equities and lift Japanese inflation expectations, spilling over to global markets.  The market could look on the US economy with more confidence after the rebound in US payrolls, including a rising trend in wages and core inflation this year in the face of falling US inflation expectations.