Don't expect yen to appreciate further

Vatsal Srivastava

The USD/JPY cross is trading just shy of 102, having drifted lower from multi-year highs 0f 105.2 in early January. After the sales tax hike which has been in effect April 1st onwards, Japanese equities and the Yen have been drifting lower (lower Nikkei and lower USD/JPY).

The underlying theme for the yen still remains gradual depreciation against the dollar in the medium term. The price action we are witnessing now is very similar to the price range of 75-80 the yen was stuck in before the BoJ governor unleashed his massive QE programme.

While the fight against deflation is far from over (BoJ has an inflation target of 2 percent), we have been seeing a consistent uptick in Japanese CPI data. In an interview to the Wall Street Journal over the weekend, BoJ governor Haruhiko Kuroda said that monetary policy alone cannot resolve the world's third largest economy's structural problems. He added that the next step of reforms will have to be undertaken by the government and the private sector or the real economy would suffer despite the wealth effect created by rising equity prices and a weaker yen - which has improved the net margins of exporters.

While previous BoJ governors have not openly spoken on foreign exchange rate policy, Kuroda has categorically said that one should not expect the yen to appreciate further against the dollar from current levels. Just to get a sense of the scale of BoJ's QE programme, we should compare it to the US Federal Reserve's balance sheet expansion. The Fed has thus far accumulated assets worth 25 percent of its total economic output on its balance sheet. The Bank of Japan would have expanded its balance sheet to a level which would be 60 percent of its economic output by year-end according to Nikko Asset Management.

It should be noted that the BoJ view is that it is winning the fight against deflation. Bulls in the USD/JPY pair and the Nikkei 225 are hoping this turns out to be incorrect, at least in the short term. A bigger 'bazooka' is what market participants are hoping for to push the currency pair past the 105 mark. On April 30, the central bank projected inflation of 1.9 percent for the fiscal starting April 2015 and 2.1 percent for FY 2016.

A prudent strategy in the USD/JPY pair is to slowly start building long positions. We will witness the typical 'risk on' trade if data disappoints in the coming weeks - weak data implies stimulus expectations implies a weaker yen, which pushed the Nikkei and Topix higher. But to what extent is the short yen-long equities trade correlated?

According to Citi research, there are three preconditions for the high degree of correlation: 1) the absence of powerful earnings drivers for Japanese corporates other than forex, 2) the non-emergence of an asset price bubble affecting either the dollar/yen rate and share prices and 3) a lack of unease about the financial system.

At the current level of 102 for the USD/JPY, these are the potential scenarios for the currency-equity correlation. In the first, in which the US economy recovers and the continued quantitative and qualitative easing by the BoJ leads Japan out of deflation, the high correlation between yen weakness and high share prices would continue. In the second, powerful earnings drivers, such as infrastructure investment to prepare for the 2020 Tokyo Olympics, emerge after a successful escape from deflation, share prices would rise even if the yen strengthened on the start of monetary tightening by the BoJ. In the third, the recovery in the US economy falters and Japan fails to put deflation behind it, as doubts creep in about the BoJ's commitment to its inflation target of 2 percent, resulting in yen strength and equity weakness. In the fourth, worst-case scenario, involving nuclear accidents and the bankruptcy of the Japanese state, the yen and equities weaken in parallel, according to Citi research.

(Vatsal Srivastava is consulting editor for currencies and commodities with IANS. The views expressed are personal. He can be reached at