Two things stand out that make JPY frustrating to trade during this risk recovery since the March nadir.
First, USDJPY has been lagging the recent weakening of USD against other major currencies as increasingly negative US real yields and threat of the so-called ‘fiscal cliff’ weighed on the USD. Second, the decrease in USDJPY’s positive sensitivity to swings in risk sentiment – with correlation to global equities having fallen to slightly negative – has raised questions as to whether the JPY is still a safe-haven currency.
The US-Japan real rate differential has been a reliable guide to USDJPY historically. However, USDJPY seems higher than warranted by the narrower US-Japan real interest rate gaps driven by aggressive Fed rate cuts, while the Bank of Japan was more constrained by already negative rates. Simple long-run charts of USDJPY versus interest rates would suggest sub-100.
A way to make sense of the seemingly higher than warranted USDJPY is the JPY sales on outbound investment by long-term investors such as pension funds and life insurers, which is an on-off development under Abenomics.Such on-off development also includes private outbound foreign direct investment spurred by surging profits, which encouraged Japanese corporates to globalise belatedly.
On the other hand, USDJPY is lower than appears warranted by the recent risk rally. Long-run charts of USDJPY versus equities point to 110+. It is tough to envisage the JPY surrendering its safe-haven currency status any time soon even as the USD has likely become the favoured safe haven, as the fall in US rates this year makes it an attractive funding currency for borrowing and carry trades. In a world of ‘risk on, lower USD’, the USDJPY pair may remain quite insensitive to risk-on/risk-off swings as both currencies continue to be used for funding purposes. For investors looking for risk-off hedges, buying JPY against AUD, NZD or NOK instead of the USD should work better.
We see a grind down in USDJPY, targeting 102 in a year’s time. Pressures from outbound portfolio investment and direct investment outflows that kept USDJPY higher than appears warranted are likely to subside, which add fundamental support for JPY strength.
Shorting USDJPY from current 105-106 levels may not be ideal, but we look for selling into higher USDJPY rather than buying into USDJPY dip.
There is increasing media speculation that Prime Minister Abe may step down given his recent health problems. While there may be some initial concern amongst investors about political instability, repatriation and the end of Abenomics, which could give JPY some temporary strength, we do not expect this to be long lasting. Abe’s successor, if Abe resigns, is likely to be chosen from the Liberal Democratic Party (LDP) and a close ally, which means that the basic contour of policies would be unlikely to change.Disclaimer applicable to recommendation
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