Abe’s election victory – safe haven status decline?
Given Japan’s constitutional limits in war participation, its neutral nature in geopolitics has been one of the reasons why the Japanese yen is considered a safe haven asset for investors, experiencing an influx of funds following uncertainty in global markets. This is despite Japan having the highest government debt-to-GDP ratio (250%) in the world, difficult demographics (falling birth rates and limited immigration) and negative interest rates (currently at -0.1%).
Following Shinzo Abe’s ruling coalition supermajority result in the October 2017 snap election, the incumbent prime minister has been given the mandate to push across anti-pacifist reform following an increasingly belligerent North Korea1. This means that investors may think twice before buying yen when there is an uptick in volatility in the international capital markets, instead favouring the Swiss franc or gold.
Monetary stimulus at full steam
Another major outcome of Abe’s election victory will be the continuation of the ‘Abenomics’ reform programme, where a core element has been to utilise monetary stimulus to address chronically low/negative inflation, which has plagued the country since the real estate asset price bubble collapse in early 1992.
Haruhiko Kuroda, the current Governor of the Bank of Japan (BoJ), has been the main driving force behind the radical quantitative easing policy, negative interest rates and innovative yield-curve-control programme2. Although Kuroda’s reappointment is highly expected in April 20183, his dovish legacy in boosting inflation (currently at 0.7%) whatever the cost will endure if he leaves4, demonstrated by the most recent BoJ board member decision to keep current policy (0.1% central bank interest rates, 0% 10-year government bond yields and Japanese Government Bond purchases of around ¥80 trillion) on hold in an 8-1 vote5. The dissenter argued for more expansionary policy6.
Strengthening economy – inflation pressures
Companies remain cautious on increasing wages and prices, despite the propagation of ‘Abenomics’, positive GDP growth for seven consecutive quarters (latest Q3 2017 reports showed annualized 1.4% growth) and a two-decade-low unemployment rate of 2.8%. Various economic reasons have been given for this delay, such as lag theory (inflation responding to a tight labour market over time) and a lower natural unemployment rate in Japan than previously estimated7. However, demand-pull inflation pressures will inevitably catch up with the economy.
Phillips curve depicting a negative relationship between annualised CPI inflation (%) and unemployment rate (%) on Japan monthly 1990-2017 data.
Given the BoJ’s unyielding resolve to increase inflation, recently announcing that it will intentionally overshoot its 2% target to entrench higher inflation expectations, the central bank is unlikely to tighten monetary policy following higher inflation in the medium term. In comparison, the remaining G7 economies have begun to, or are planning to, reign in their post-crisis monetary easing, having achieved, or on course to achieve, their inflation targets. As a consequence of this, interest rate differentials will increase between Japan and other advanced economies. Combining increasing interest rate differentials with higher inflation in Japan will lead to a depreciation of the yen with major currency pairs.
Time-series plot showing USD/JPY and the 10-year government bond yield differential between Japan and the US moving in tandem after 2000.
Champion of the TPP
The Trans-Pacific Partnership (TPP) talks during the recent APEC summit depict not only Japan’s subtle advances in filling the power vacuum left following US withdrawal, but also its efforts to push forth its economic agenda8.
With access to cheaper imported basic machinery components and textiles from member countries such as Malaysia and Vietnam, the TPP free trade agreement will be a boon for large Japanese technology hardware multinationals and fashion retail companies such as Fast Retailing, which owns the world-famous fashion brand UNIQLO and alone has a Nikkei 225 stock index weighting of 8.4%. Lower-priced intermediate goods mean that Japanese firms will be able to offer final goods to TPP and non-TPP countries at a lower price, boosting exports and revenues, measured in yen.
A successful TPP collaboration between the 11 countries of the Pacific Rim will boost Japan’s overall trade in international markets. However, the offsetting import and export effects mean that the net impact on Japan’s trade balance, a subset of the country’s current account surplus (another reason why Japan is a safe-haven currency), will be difficult to gauge until final amendments on the TPP have been agreed upon9.
Bottom Line
1st Investment: Recommend a long USD/JPY position based on increasing Asian geopolitical risks, diverging interest rate differentials and an unexpected pick-up of inflation in Japan.
Investment Horizon: 12 months (or 6 months if 6 month cap)
Current: 112.06
Price Target: 120
Risks: Fears of a lacklustre US economy limiting US rate rises, an influx of volatility in world markets or a real estate market bubble risk forcing the BoJ to abandon monetary policy; all of which will lead to a higher yen.
2nd Investment: Recommend a long position on Nikkei 225 index based on potential for large companies in highly weighted industries to benefit from TPP (likely to be signed in first quarter of 2018), strong Q3 corporate earnings results and potential inflation to increase the stock index in yen terms.
Investment Horizon: 4 months
Current: 22,523
Price Target: 25,000
Risks: Fears of S&P 500 bull market ending (if US tax cut plans fall through) will impact Nikkei 225 as both indices have a strong positive correlation, potential Nikkei 225 index correction following nearly 20% rise in just 2 months or TPP talks faltering may cause the Nikkei to fall.
References:
https://www.dailyfx.com/forex/market_alert/2017/04/25/CHF-Rather-Than-JPY--Becomes-Haven-Currency-of-Choice.html
https://www.ft.com/content/028d47a8-7faa-11e6-bc52-0c7211ef3198
https://www.bloomberg.com/graphics/2017-who-will-be-the-next-boj-governor/
https://www.bloomberg.com/view/articles/2017-10-29/bank-of-japan-is-in-kuroda-mode-even-if-he-leaves
https://www.ft.com/content/4f584ec2-bde6-11e7-b8a3-38a6e068f464
https://www.reuters.com/article/us-japan-economy-boj-minutes/bank-of-japan-september-meeting-minutes-members-debated-benefits-of-ycc-idUSKBN1D601F?il=0
Mizuho September 2017 Global Macro Outlook.pdf
https://www.ft.com/content/82c29b4a-c616-11e7-a1d2-6786f39ef675
https://asia.nikkei.com/Politics-Economy/Economy/TPP-11-narrowing-down-areas-of-contention