USD/JPY Outlook
In 2006, the Japanese Yen was one of the currency market’s biggest losers. However if you have only been watching the value of USDJPY, which ended the year less than a percent away from where it started trading in January, you may have not realized that. Instead, the Yen lost most of its value against the Euro and British pound , with the currency falling 10 percent against the former and 12 percent against the latter.
In fact, the depreciation was so significant that it drove EUR/JPY to an all-time high and GBP/JPY to an 8 year high. The massive divergence between the Yen’s performance against the dollar and the other major currencies stemmed from the uncertainty surrounding the US economy throughout the past year. However the Yen’s performance against the other majors provides a far more accurate reflection of how the market feels about the currency pair. With the Bank of Japan standing pat after their one interest rate hike in July, traders soon realized that interest rates would continue to remain low throughout the year, making carry trades against the high yielding non-US dollar pairs still a viable investment. As we look ahead to 2007, we will begin to see the Japanese economy reap the benefits of a weak Yen, which should pave the way for another rate hike by the Bank of Japan, and also increase the risk of carry trade unwinding and reserve diversification.
Recent Economic Weakness should be Short-lived
Throughout 2006, the Japanese economy has struggled to grow. After reporting GDP growth of 0.5 percent in the second quarter, Japan’s economy expanded by a mere 0.2 percent in the Q3. Domestic spending has been the country’s biggest problem with retail sales falling 0.2 percent in the month of October, after having already fallen 1.5 percent the month prior. With flat wage growth in October, it is not surprising that consumers have remained thrifty. However, Japanese exporters have benefited significantly from the falling value of the Yen, which should eventually filter into higher wages. The quarterly Tankan survey also increased to the highest level since September 2004, which indicates that large manufacturers have become more optimistic about the business conditions in the coming quarter. Even though the US is Japan’s largest trade partner, exports to the Eurozone and the UK have increased significantly over the past few years. In the month of September alone, Europe’s trade deficit with Japan surged by 21 percent. This could increase even further after the currency’s recent drop. As an export dependent nation, Japan benefits significantly from a weak currency. The most obvious benefit is the fact that the weaker Yen makes Japanese goods more attractive to foreign nations, but the less obvious benefit is the added revenue that a weak yen could bring for the foreign exchanging hedging operations of Japanese corporations Given that many Japanese corporations do a great deal of business abroad, it is important for them to protect their exports and foreign earnings from a rapid appreciation in the Japanese Yen. When the yen depreciates, these hedging operations can become sources for additional revenue. Even though corporations have recycled a lot of their profits back into equipment and other capital investments, we should also begin to see stronger corporate profitability translate into stronger wages. In addition, the stock market is up 20 percent since June, which should help boost the overall optimism in Japan. Higher asset prices and a recovery in employees’ incomes will be needed before the BoJ will lift interest rates.
Another Interest Rate Hike in 2007
The longer the currency remains weak, the more stimulative it is for the Japanese economy, which should pave the way for another interest rate hike in 2007. The Bank of Japan has been extremely careful about raising interest rates last year. Even though the market expected another rate increase after their first 25bp hike in July, the central bank felt that the country needed time to absorb the first dose of tightening in 6 years. With a new Prime Minister steering the country, politicians are not eager to see the central bank deliver anything that could threaten the country’s already fragile recovery. Like most politicians, Prime Minister Abe is looking to prove himself in the early months of his term. To do this, he probably wants to see growth increase for a few more months and actually stabilize so that a rate hike would not take a big toll on growth and as such, keep their approval ratings stable. Prime Minister Abe is far more nationalistic than his predecessors, which means that he believes in a stronger Japan. This suggests that he will not be completely averse to a stronger yen. They also need to see inflation increase, but given the recent rise in oil prices, there is a good chance that the downtrend in consumer prices could reverse.
Carry Trade Unwind
Once we get the first whiff of a serious potential for an interest rate hike, rather than open threats, expect carry trade unwinding to pick up steam. Right now carry traders are still safe with Japanese interest rates remaining low and other central banks such as the UK, Australia and New Zealand still considering raising rates. However after having made great profits over the past few years, carry traders are very cautious at the moment and are probably willing to bail at the first sign of trouble. The market expects the next interest rate move in the US to be lower rates rather than higher, which doubles up on the reason for carry traders to bail out should the Japanese government step aside and allow the BoJ to tighten monetary policy. The magnitude of an unwind will depend upon who blinks first. If Japan moves to raise rates before the US decides to lower them, the unwind may be limited because the carry advantage of the US over Japan still remains very large and based upon Japan’s last move, they can wait months before changing rates again. If the US blinks first on the other hand, even though the carry advantage remains large, the Fed is usually not a one hit wonder, which means they will most likely be following their rate change with another. Therefore the prospect of a quickly narrowing interest rate spread will be the main trigger of a carry unwind. Reserve Diversification
Should the US dollar extend its slide, talk of reserve diversification will escalate because the central banks will be looking at not only the possibility of lower interest rates or yield going forward, but also a decline in the notional value of their investments because of foreign exchange fluctuations. The yen is set to benefit significantly because many central banks have been underweight the currency in their reserve allocations and with 0.25 percent interest rates, there is far room to go up than to go down. Russia has already announced that it is adding yen to their reserves along with the Reserve Bank of New Zealand. Although the Swiss National Bank did not verbally admit to it, their data also indicates that they have been quietly building up holdings of yen after having dumped all of their yen holdings between 2001 and 2004.
China
Meanwhile the sleeping giant continues to be China. With Paulson leading the US Treasury, the government has taken a buddy versus bully approach to persuade China to increase the value of their currency. In the latest Treasury Report on Foreign Exchange activities, they even tamed down their attack on China for not allowing enough currency flexibility. As a proxy for Asia, the Japanese Yen should continue to benefit from further Yuan revaluation.
North Korea - Still a Hotspot
Finally, we still have one eye on North Korea. Even though the country has returned to the six party talks, they are far from reaching a deal that would persuade them to dismantle their nuclear program. Should the talks break down and North Korea decides to retest another nuclear missile, it would make a lot of investors nervous. Uncertainty is never good for a country’s currency and unfortunately for Japan, their geographical proximity to North Korea puts them at great risk of getting involved in the conflict. So far, it is believed that North Korea’s missiles only have the power to reach Japan, which means that they can be attacked. Japan has already announced sanctions on North Korea, banning trade and travel between the two countries. Japan is only a very small trade partner of North Korea’s, which means that economically, the sanctions should only have a limited impact. Conclusion
The weakness of the Japanese Yen over the past few months should lend significant support to the economy in 2007. Growth and wages should improve, which would pave for the way for an interest rate hike by the Bank of Japan and resurrect both carry trade unwinding and reserve diversification. However the fate of USD/JPY is mostly dependent upon what the US Federal Reserve does with interest rates because any rate changes by Japan will most likely be another one hit wonder – where we have to wait months before another move. When the US embarks on a new monetary policy cycle (tightening or easing) on the other hand, they tend to follow it up with a series of moves, which means that should the US begin to lower interest rates, we could see a far larger and longer lasting reaction in USD/JPY.
Technical Outlook
The USDJPY continues to challenge the 8 + year resisting trendline. In October, this same line was broken, but the follow through failed to materialize. In mid December, the USDJPY finds itself right back at the line. Weekly RSI has pushed above the midpoint of 50, which is bullish, and the next resistance level is the October high at 119.87. A rally past there exposes the 12/5/2005 high at 121.38. Wave structure suggests that this could be the 3rd wave of a 3 wave (A-B-C) corrective move higher that began at 101.67. This would be the final leg up for the dollar which would then give way to the long term downtrend. A break of 121.38 instills more confidence in the upside and gives way to 128.61 – which is where wave C (beginning at 108.96) would equal wave A (101.67-121.38). A setback encounters support at what may be the bottom of wave 2 of wave C at 114.42. 114.42 needs to hold for wave C up to remain healthy.
USDJPY Weekly Chart (Source: FXTrek Intellicharts)