End of ZIRP? – Politics the Deciding Factor

The Bank of Japan has had a Zero Rate Interest Rate policy in place for over a decade, as the country has been in a battle with deflation for nearly that long.  Although analysts have been predicting a change in this ultra accommodative monetary posture for the past two years, this is the year when those forecasts may actually come true.  Recently Bank of Japan Governor Toshihiko Fukui, noted that ”With the year-on-year change in the CPI becoming zero percent in October, it is clear to everybody that it is nearing an end.” He is suggesting in a not so subtle fashion that the BOJ may be ready to abandon this monetary straightjacket sometime next year. In fact Mr. Fukui described the quantitative easing as "a very unusual policy," saying the current framework restricted the central bank's free hand in monetary policy.

However Mr. Fukui faces serious political and economic barriers to achieving his goal.  The government of Prime Minister Koizumi has been extremely resistant to any tightening of monetary policy.  Japanese political leaders are terrified that any rate hikes could stifle the country’s fragile recovery and tip the world’s second largest national economy into its fourth recession in ten years. In fact, as recently as November, LDP party policy Chief Hidenao Nakagawa warned that "the BOJ has no independence when it comes to policy targets," and "if it does not understand this, we need to consider amending the BOJ Law." In the meantime the economic data has been less than supportive taking three steps forward and two steps back. Case in point were the latest GDP figures which missed their mark by printing only 1.0% gain versus expectations of 2.3% gain. Similarly household spending has only registered two positive year on year readings out the past twelve months of data. Most analysts are absolutely convinced that the BOJ will not act on interest rates until Japanese consumer spending demonstrates a sustainable positive trend.  Nevertheless, there are signs of growth in the Japanese economy. The GDP for the April to June quarter was revised upward to a very respectable 2.9% growth rate and the positive Household spending numbers were produced in the most recent months, suggesting that the Japanese consumer may be finally coming out of his long term hibernation. With unemployment at a low 4.5% rate, job to applicant ratio reaching a six year high of .98 and the Eco Watchers survey comfortably above the 50 boom/bust level, chances appear quite strong that Japanese consumer spending could accelerate as 2006 begins. Only a spike in the oil prices above the $70 level could derail this scenario putting a chill on both global demand – vital to Japan’s export sector - and crimping any potential growth in consumption as the Japanese will be forced to address materially higher energy costs rather than increase their spending. With the government and the central bank in a battle, perhaps the next move with rates will not come until Koizumi leaves office, which is expected to be in September 2006.  As he bows out and a more hawkish leader comes in, the BoJ may finally be given more flexibility to do what they think is best for the economy.

Revaluation – Yuan or Yen?

The FX world has been focused on the issue of Chinese Yuan revaluation for the better half of 2005. In July of this year the PBOC actually revalued the Yuan for the first time in 9 years appreciating the currency by 2.15%. As a result, the yen reacted positively with USD/JPY dropping 300 points in a matter of 2 days.  The yen of course benefits from Yuan revaluation in two ways. First, as the largest exporter to China, Japan earns more income from its business interests in Mainland China as the Yuan appreciates against the dollar. Secondly, as the primary trading competitor of China on the world stage, Japan achieves a cost advantage in its products as denominated-denominated goods rise in value. With Chinese exports to the US setting monthly records, the political pressure on the Chinese to revalue remains intense. Senators Schumer (D-NY) and Graham (R-SC) have introduced legislation that would impose a 27% tariff on all Chinese goods. Many analysts believe that the Chinese revaluation in the summer of 2005 was an attempt to preempt such legislation from being enacted. And most market observes believe that further Chinese revaluation announcements will take place as a response to increasing pressure from the Bush administration during the sensitive election year in the United States.

However, while the issue of Yuan revaluation is well known in the currency markets, the idea of yen intervention has not been given nearly as much attention. The recent run up of the dollar against the yen has been a boon for Japanese exporters, as the country has amassed an $80 Billion goods trade surplus versus the United States.  With USD/JPY now hovering around 120, pressure is building on Japan to intervene in the markets to strengthen their currency. Typically, the export oriented nation has only intervened to weaken the yen, but recent statements by President of the Automotive Trade Policy Council, Stephen Collins should make traders take pause and consider the opposite possibilities. Mr. Collins stated that "Japan has played this game (of currency intervention) hard and highly successfully and to our industry's, and we think the U.S. economy's, demonstrable harm. We have pushed hard to get much more attention and something more credible, more serious from the Treasury department. While all of the attention has been on the new guy on the bloc, China, Japan flew under the radar screen and has joined in on the pointing fingers at China. The reports from the G7 were extremely discouraging and very damaging to U.S. interests. There is no excuse for the G7 to get together and sit around talking about China when the currency imbalances and Japan's policy of strongly encouraging yen weakness isn't even discussed." If Mr. Collin’s views become popular during the upcoming election season, the pressure on Japan to conduct reverse intervention could send USD/JPY tumbling, regardless of the carry trade spread.


While 2005 was undoubtedly the year of the carry trade which saw USD/JPY soar to multi year highs, 2006 may see many of those same trends reverse. Better economic growth and more importantly steady increase in Japanese consumer spending could finally motivate the BOJ to abandon it’s decade long Zero Interest Rate Monetary policy, while the US Fed – faced with a slowing housing market may conclude its two year long monetary tightening policy.  This major shift could give speculators a good reason to abandon their short yen carry trades. We already began seeing evidence of this in December 2005 when USDJPY collapsed following the Fed’s rather mild shift of stance following the year’s final FOMC meeting.  Meanwhile, China, as well Japan itself, pressured by political outcries for revaluation during the upcoming US election season may be forced to intervene in the markets, sending the USD/JPY lower. On the other hand, if US growth continues its torrid 2005 pace, the Fed may raise short term rates to 5% or higher in which case the carry trade will continue potentially taking USD/JPY to 130 or higher as a result.

Technical Outlook

It has been an exciting year for Japanese Yen traders after the pair started 2005 by coming within 100 pips of the key psychological 100.00 level.  However yen bulls shortly lost control of their dominance at which time the market saw a dramatic reversal in fortune for the pair as dollar traders began pushing the pair higher. At the time a major reversal signal was issued during the second quarter when USD/JPY broke above both the trend line that dominated the price action since the end of 2002, and the 52-week SMA, thus giving the greenback total control of the price action. The magnitude of the dollar rally was so significant that the one way uptrend easily broke above the psychologically important 120.00 handle with minimal retracements to a level not seen since 2003.

As we near the 2006, the pair should remain in a trend mode, but given the recent price action, the beginning of the year will most likely see continued Yen strength against the dollar, with the key levels sighted around 114.50, a level established by the 38.2% Fib of the 135.16-101.71 USDJPY sell-off and the top of the Head and Shoulder formation established during April of 2004. The next key support to be aware of is clustered around the 112.00 figure, a level marked by the numerous rejections of the price along with the top of the summer of 2005 consolidation. A subsequent reversal will most likely see the pair once again resume its ascent and aim for 118.43, a 50.0% Fib of the 135.16-101.71 move, with a further rally to the upside heading back above the psychologically important 120.00 level. If this level is broken, it opens the door for a move to the 125.00 level.