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Japanese Yen Strength is its Own Undoing – Watch for Weakness

Japanese Yen Strength is its Own Undoing – Watch for Weakness

David Rodriguez, Head of Product

Fundamental Forecast for Yen:Bearish

The Japanese Yen finished the week higher versus the fast-falling US Dollar, but key disappointments in domestic economic data and Nikkei 225 losses kept the JPY lower against other major FX counterparts.

Historically we have seen the Yen strengthen (USD/JPY weaken) on domestic equity market sell-offs. And yet this time is different for a key reason—both the Yen and the Nikkei stand to lose if the domestic economy continues to underperform. A sell-off in Japanese stocks into the fiscal year-end (March 31) left the Nikkei in negative territory for fiscal year 2015—the first such annual loss in three years. Profit warnings and disappointing Bank of Japan Tankan survey result forced further sell-offs on April 1, and current price momentum and broader sentiment favors further Japanese equity weakness.

The Yen could nonetheless continue to weaken alongside stocks for one simple reason—economic underperformance will encourage the Bank of Japan to cut interest rates further into negative territory. Indeed, the BoJ sent shockwaves throughout global markets as it surprised most and cut its benchmark overnight rate to -0.10% at its January meeting. Domestic rates subsequently plummeted, and Japanese Government Bond yields are now negative for bonds maturing in under 10 years. Holding funds in Japanese Yen is an expensive proposition if you’re required to pay the government for lending it money.

Continued turmoil and Yen strength in itself lead many to believe the BoJ will move rates lower at its April 27 meeting, and this will only make it worse for domestic investors to receive any real (or nominal) rates of return on their JPY holdings. It is little surprise that individual investors own a miniscule share of total outstanding Japanese Government Bonds—few rational investors would want to pay interest to lend money. The Bank of Japan itself is far and away the largest holder, and their Quantitative Easing program already buys twice the monthly supply of newly-issued JGBs. At some level this represents opportunity—buy government bonds with the expectation that prices will rise as the BoJ steps in. Yet this is also a clear market distortion, and a jump in bond market volatility prices confirms that buying JGBs is a risky proposition.

Thus we may continue to see capital flow out of Japan which itself will keep pressure on the JPY exchange rate. The USD/JPY in particular seems likely to test near-term lows, but that is just as easily a function of US Dollar weakness instead of Yen strength. It would take a fairly significant shift in Bank of Japan policy to improve outlook for the domestic currency.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.