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A few days ago, Japan revealed the biggest fiscal budget plan of 92.4 trillion yen ($1.1 trillion) in its history for the next fiscal year (FY 2011, starting in April 2011). The number sounds big, but it is just a 0.12% increase from the budget of 92.3 trillion yen in the current fiscal year (FY 2010). Since the budget will be partially financed by one-off funding from previous savings, the projected borrowing needs of the Japan government in the next fiscal year will be 5 billion yen (about $60 million) lower than its debts in FY 2010.

The economic rebound in Japan in 2010 has been pretty strong so far, after the seven-quarter drop in GDP in 2008 and 2009. The average growth rate of the real GDP in the first three quarters in 2010 over the same period in 2009 is about 4.9%, compared to 2.9% in the US. Japanese domestic consumption was the major driver behind the rebound in the first half of 2010. Now private investment also began to pick up. But deflation still threatens Japan’s economic growth, as CPI dropped below 2% in the second half of 2010. Then, a week before Fed decided to establish QE2, BOJ set up its own QE program of 35 trillion yen. The Nikkei 225 index had risen by more than 10% since then. Currently, USDJPY is close to the multiple-year low at 80, down from 92 at the beginning of the year, largely consistent with the strong performance of Japan’s economy.

Looking back at historical data, we can find that in certain periods, USDJPY is positively correlated with the one year yield gap between the US and the Japanese government bonds. 2010 is one of these periods. Correlation between USDJPY and the one year yield gap has been 0.82 in 2010. Chart 1 presents the moves of USDJPY and the one year yield gap between two government bonds.

Chart 1: USDJPY and One Year Yield Gap

After QE decisions in both US and Japan, yield curves of government bonds steepened. Based on the experience of QE1 in the US, yield curves in both countries are likely to continue steepening until the expiration of QE in 2011. The one year yield gap between two government bonds is now near the multiple years low, 150 base points on December 28, 2010. This yield gap is very close to the yield of one year Japanese government bond now (140 base points). For Japanese investors investing in short term US treasuries, this narrow yield gap is unattractive. Therefore, barring any economic shocks, it is likely that those Japanese investors with short term treasuries in their portfolio will reduce their exposure, to shift to other higher yield assets, i.e. long term US treasuries. This will widen the one year yield gap on the margin in 2011, though slowly: uncertainties in various regions (Europe and China) tend to keep yields in both countries low. In 2011, USDJPY is going to move higher along with the yield gap, after the gap becomes attractive again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Focus on Japan: Economy, USDJPY and Yields of Government Bonds