The USD/JPY is clearly being pulled in several directions with the fundamentals. After a somewhat disappointing trade balance reading (up slightly from -852bn JPY to -800bn JPY), the USD/JPY rose to 90, and there were rumors from a senior cabinet member that it would reach 100. Market enthusiasm and displeasure has caused it to fluctuate wildly in its current range, with the BOJ's announcement of further easing, followed by speculation that the amount was not enough to provide significant support.
There will be a lot of noise over the next few months, but the lingering question will remain: is there potential for an "Abe Moment" for the Yen that would bring forward strong and lasting downward momentum for USD/JPY?
In the short run, the SP500 has outperformed the Nikkei much more than what the recent trend of the USD/JPY would suggest. This is either an arbitrage opportunity or the signal of a regime switch. We think that the SP500 has some upward potential, but this would imply a drop in the 1-month change of the USD/JPY.
The current reading of the real rates spread suggests that the USD/JPY is too high. However, the 10-year inflation swap stands at 0.70. If the "Abe-implied" inflation target of 2% is reached, the USD/JPY would stand at around 92 (close to today's value).
The rebound in the USD/JPY happened at a time when the M1 ratio suggested otherwise. If M1 increases much more in the US than in Japan, then, according to the chart below, the USD/JPY should decline. The economic rationale here is that more money created in the US would lead to more inflation and thus a weaker currency to compensate for the loss in competitiveness. Another explanation could be that the more liquidity is created by the central bank, the more capital outflows weigh negatively on the currency. In the latter case, monetary base (which encompasses banks reserves but not deposits), would be better utilized.
A quick reading of those 3 charts suggests that there might be some rationale for tactical shorts on the USD/JPY. Technically, the next potential resistance area stands between 93.30 and 94.12 (long-term resistance line and retracement of 38% of the downtrend 2007-2011). This resistance could trigger a correction.
The medium run picture is much more puzzling.
US long-term yields have long been correlated with the USD/JPY. After a structural break in 2009, they recoupled in 2011. Yet, the link broke again in late 2012. There is no way that US 10-year yields will reach 5.0% anytime soon. This leads us to the possibility of a structural break.
In the aftermath of the financial crisis, the USD/JPY clearly imposed itself as a risk-on/risk-off currency. Yet, the link between the pair and the VIX has broken down again, suggesting a new "status" for the Japanese currency.
If the USD/JPY is no longer driven by risk aversion, it might reflect fundamentals. Many analysts resort to the current account, the story being that an aging population combined with higher energy needs would reduce structurally the current account balance. Let's have a look:
- The link between the current account balance and the USD/JPY is weak. The reason is simple: a positive current account balance does not show what happens on the capital account (portfolio flows);
- In the case of Japan, excess saving has, for years, led to a negative capital account (structural outflows). As can be seen above, the capital account deficit hovers around -1%. Barring FX intervention, any current account reading below 1% means net outflows and thus a weaker yen;
- In addition, the link between current account has been skewed by ZIRP (0% interest rate policy) and the yen-funded carry trade strategies during the 2006/2008 period;
- The chart above also raises the following question: is it the sign, level, or the trend of the current account that matters as a driver of the exchange rate?
This leaves many uncertainties. Yet,
On the positive side (USD/JPY bear): The recent decline in the current account is mostly attributable to energy. If Japan restarts part of its nuclear plants, the surplus will return. A look at the chart below suggests that this link (energy/current account) should be taken seriously. The aging of the society may also reduce the structural outflows of domestic saving.
On the negative side (USD/JPY bull): An aging society (the share of population 65 years and older is slightly above 25%) saves less and consumes more. It means more imports and less external surplus. If Abe's expansionary fiscal policy amplifies the public deficit, the net impact on external account will also be negative (lower domestic saving).
This is where we stand for the USD/JPY. There might be some possibility to play a short-term exhaustion of the recent sharp upward move around the 93 resistance (the implicit inflation target is priced into the real rates spread).
Yet, from a medium run perspective, any view on the pair depends heavily on a mix of political (energy policy, fiscal stimulus, BOJ new status) and economic factors (main drivers of the current account balance, wage reaction to the stimulus or imported "inflation") that makes any forecast seem more like a bet than thorough analysis.
My view is that investors may be willing to believe in a possible "Abe Moment" for a while. But let me emphasize the importance of the energy component of the current account deficit, as a nuclear policy revival would clearly be negative for the USD/JPY.