2010 Currency Outlook: JPY
Narrowing of US-Japan yield gap and the 'laissez-faire' stance of the Japanese government were the main reasons accelerating Japanese yen's rally against the dollar in 2H09. 3-month LIBOR for USD-denominated loans has been trading been below that of yen-denominated loans since August 24 while USDJPY plummeted to as low as 84.82, a level never seen after 1995, in November. Not until a stronger-than-expected November employment report in the US which spurred speculations of an earlier (by June) Fed rate hike had the dollar rebounded against the yen. However, the yen remains strong compared with historical average.
A strong domestic currency, coming along with weak economic growth and deflation, made the Japanese government turn more cautious about the yen's strength. The new Finance Minister, Naoto Kan, said that the currency should be weaker and the Ministry of Finance (MOF) will work closely with the central bank to bring the yen to 'appropriate levels'.
In 2010, we believe several factors will push Japanese yen lower against major currencies. These factors include the BOJ's re-entrance to the QE regime, government intervention and exit strategies by other central banks.
Economic Outlook: Deceleration in GDP growth, persisting deflation and deteriorating fiscal deficit are forcing policymakers to take more aggressive fiscal and monetary actions in 2010.After contracting for 3 consecutive quarters from 2Q08 to 1Q09, the Japanese economy recovered and grew +2.7% qoq in 2Q09. However, the pace of expansion slowed down quickly and GDP growth was more than halved (+1.3%) in 3Q09. The market anticipates the Japanese economy may stay flat in 4Q09 and 1Q10.
At the end of 2009, the cabinet approved the FY2010 (Apr 2010 to Mar 2011) budget and a plan of growth strategy which is expected to achieve nominal GDP growth of over +3% and reach GDP growth of 2% on average through 2020. However, most economists in the street doubted the effectiveness of the plan.
Strength in Japanese yen should continue to cripple exports and pressure the Japanese economy, at least until 2H10. According to the World Bank latest forecast, Japan's GDP will expand +1.3% in 2010, compared with +2.5% in the US and +1% in the Eurozone. Japan will also be losing its status as the world's second largest economy to China in 2010.
S&P downgraded Japan's credit rating outlook to 'negative' from stable on January 26 as the Democratic Party of Japan (DPJ)'s policies 'pointed to a slower pace of fiscal consolidation than we had previously expected'. Japan's rating can be lowered from the current AA if economic data 'remain weak' and plans to boost growth are 'not forthcoming'. The rating agency forecasts Japan's net general government debt to GDP will peak at 115% of GDP over the next several years. Against a backdrop of fiscal deterioration, it's necessary for the government to tighten budget for FY2010. However, if economic growth proves to be unsustainable and weakens again, the government may be force to implement more stimulus measures. Therefore, it's a real headache for policymakers.
At the same time, the deflationary trend is gaining momentum. The CPI excluding fresh food has been declining on annual basis since March 2009. Although the pace of decline moderated in November and should slow further in December, we believe it's due to lower base effect from oil prices, rather than fundamental change in the Japanese economy. The downtrend continue through 2010 and 2011 amid high output gap. Deflationary environment also weighed on consumer spending and the domestic demand deflator plunged -2.9% yoy in the third quarter, the steepest decline since 1957!
Deflation is detrimental to fiscal problems as the gap between huge government spending and shrinking tax revenue should widen further under deflation.
BOJ to Extend Easing: Decline in growth and rising deflationary pressure should trigger the Bank of Japan to implement more expansionary measures. Although the central bank made no change at meetings on December 18 and January 26 after releasing a 10 trillion yen liquidity program after the emergency meeting held on December 1, policymakers pledged to maintain an 'extremely accommodative financial environment'.
At the January meeting, Governor Masaaki Shirakawa said that 'It will take time before we can see prices rising to favorable levels' while Finance Minister Naoto Kan said in parliament that he believed 'more can be done' by the central bank to combat deflation. These indicated the government is ready to extend both conventional and unconventional measures.
As the policy rate has been brought to almost zero, the BOJ will adopt measures other than directly taking down interest rates. The several options the central bank may consider include increasing the amount of money injected through its new operation from the current 10 trillion yen to 20 or even 30 trillion yen, extending the majority of the operations from 3 months to 6 months as well as purchasing JGB outright (Rinban).
The need to expanding QE is harmful for the yen as other central banks, especially the Fed and the ECB, are planning about exit. Most of the Fed's special liquidity will expire on February 1, 2010. The amounts provided under the TAF will continue to be scaled back in early 2010. The anticipated expiration dates for the TALF remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. At recent ECB meetings, President Trichet reiterated ' the Governing Council will continue to implement the gradual phasing-out of the extraordinary liquidity measures that are not needed to the same extent as in the past'. Divergence in central banks' perspectives in 2010 should widen interest rate differentials between JPY and USD, as well as JPY and EUR.
Government Intervention: Prior to the election, Financial Minister Fujii stated clearly that he did not support a weak yen and opposed intervention. It was in contrary to other central banks which at least verbally threatened the harm a strong currency will have on domestic economy. However, things began to turn the corner towards late last year and Fujii warned about the 'one-sided' movement of Japanese yen and the government is ready to contact US and Europe if necessary.
As the Deputy Prime Minister, Naoto Kan, took over the role a Finance Minister in early January, he expressed his favor towards a weaker yen. In his inaugural press conference, Kan said that he wanted to see the yen 'weaken a bit more' and his team will 'will make efforts to make the yen an appropriate level while considering various impacts on the economy that may be caused by currencies'. On his second day in office, Kan said that 'currencies of course should be determined by markets, but I must be aware that I have the right and the responsibility to take action in emergency situations', indicating possibility of intervention.
The last time Japan intervened currency was in 2003/04. The BOJ sold 14.8 trillion yen in the first three months of 2004, after record sales of 20.4 trillion yen in 2003. Japan hasn't sold the yen since March 16 2004. At that time, the yen was trading at about 109 dollar.
The yen will be the Major Funding Currency Again: High liquidity, low carry cost (interest rate) and low volatility are key factors for being a good funding currency. While all of JPY, USD and even CHF satisfied the first 2 criteria, JPY was more volatile than the other 2 in 2009. We believe this is a major reason that investors favored USD and CHF, rather than JPY, as the funding currency last year. We believe JPY volatility will start to decline if the Japanese government showed higher determination to intervene or to prevent strength in the yen.
The SNB demonstrated a good example on reducing volatility by intervening strength in Swiss Franc. In March, the SNB announced to it would act to prevent any further appreciation of the Swiss franc against the euro. Measures included increasing liquidity substantially by engaging in additional repo operations, buying Swiss franc bonds issued by private sector borrowers and purchasing foreign currency on the foreign exchange markets. The EURCHF had been trading above 1.5 for most of the time since then in 2009 and volatility of the currency pair reduced substantially.
Similar pattern was seen in USDJPY when the Japanese government intervened the yen during 2002 to 2004. The chart showed that implied volatility in the currency pair was significantly lower than that in 2008 and 2009 when the government adopted a rather tolerant approach to the yen's fluctuation.
In the near-term, we believe currency movement will still be dominated by yield differentials as the Fed and the ECB are reluctant to admit they are about to exit stimulus measures. Moreover, uncertainty over financial regulations in the US, step-up in tightening in China and the pace of recovery in the US may trigger fluctuation in the FX market. However, in the medium- and long-term, the yen should depreciate, especially against USD and EUR with the help of accommodative government policies amid dismal economy in Japan.
