Japanese Yen to Decline as Yield Outlook Takes Center Stage

A broadly firmer tone to US economic data saw a broad re-pricing of the market’s Federal Reserve interest rate expectations through December, with a Credit Suisse gauge tracking priced-in interest rate expectations rising to the highest level since October to show traders now forecast the US Federal Reserve will add 108 basis points to borrowing costs over the next 12 months. Meanwhile, the latest commentary from the Bank of Japan suggests policymakers have moved towards the dovish side of things, stressing that overcoming deflation is a critical challenge and threatening that CPI at or below 0% will not be tolerated. This hints that the Japanese central bank is starting to cave in to pressure from the Ministry of Finance to maintain its liquidity-boosting asset purchase programs, a prospect that promises to underpin domestic bond prices and keep yields contained as the government issues a record amount of debt to finance the gargantuan fiscal deficit.

On balance, this monetary policy landscape points to USDJPY gains. Japan’s savings rate is high relative to other developed countries, reflecting the expense of living on an island with limited space and scarce home-grown resources. This translates into Japanese investors’ preference for safe, liquid assets that offer stable income over a long period of time. Typically, this means government bonds. While both Japan and the United States will have to introduce a good bit of new supply to finance their deficits, the latter will not have a central bank that is actively supporting prices and keeping a lid on yields. Indeed, the Fed ended its purchases of US Treasuries in October, suggesting the promise of higher returns will encourage Japanese investors to favor US-denominated debt as their asset of choice. The markets have taken notice, with the yield on the benchmark 10-year US Treasury note now outstripping its Japanese counterpart by the largest margin since August 2008. This spread is now over 92% correlated with USDJPY, suggesting that the pair may rally as a hefty docket of US economic data culminating in the always-important Nonfarm Payrolls report threatens to skew the yield balance even further in favor of the greenback.