Currencies | Mar 01 2012
– Yen has had a weak start to 2012
– CBA suggests cyclical and structural factors have contributed
– Peak for yen has likely passed
By Chris Shaw
So far in 2012 the Japanese yen has fallen by 7.25% on a trade-weighted basis and in Commonwealth Bank's view the recent weakness reflects both cyclical and structural factors.
The bank's chief currency strategist and head of international economics, Richard Grace, takes the view that even if the cyclical factors driving a weaker yen dissipate, the structural issues imply the peak for the yen has passed.
These structural factors include the fact that for many years Japanese export volume growth has lagged the growth in other Asian nations. At the same time there has been strong growth in imports, such that Japan has swung from a trade surplus to a trade deficit.
Much of this can be attributed to higher energy imports, which has been needed to replace lost nuclear production. Given Japanese nuclear production is unlikely to return to full strength near-term, Grace regards the Japanese trade balance as structurally weaker.
Grace estimates the Japanese current account surplus will average 2.3% of GDP over the next few years, down from a 15-year average of 3.1%. From this viewpoint a weaker yen appears appropriate given a structurally smaller current account surplus.
A structurally higher energy import bill also has implications for Japan's terms of trade, Grace suggesting a deterioration in this measure should also apply some downward pressure on the yen.
Another structural issue Japan has to face is weak demographics. The Japanese population continues to age, which means as domestic savings decline foreigners will need to fund more of Japan's public sector debts.
As the point at which the Japanese stock of public debt exceeds household financial assets comes closer, the Japanese government may need to look to other sectors, overseas included, to finance government debt. This will either force the yen to weaken or Japanese bond yields will need move higher to attract foreign investment.
With respect to cyclical factors driving the yen, Grace notes the latest was a change in policy by the Bank of Japan (BoJ) announced last month. The policy set a specific inflation target of 2.0% and was accompanied by an increased Asset Purchase Program (quantitative easing).
This two-pronged change in policy demonstrates a stronger resolve on the part of the BoJ, especially as BoJ comments attributed some of the weakness in the economy in recent quarters to appreciation of the yen.
As well, Grace notes USD/JPY risk reversals are now skewed toward USD/JPY calls for the first time in many years, while stockmarkets have been on an upward trend over the past several months. The Japanese market lagged its global peers until recent weeks, but strong gains since the BoJ meeting last month have prompted Japanese investors to sell the yen and invest more capital offshore.
Grace points out a weaker yen lifts valuations of Japanese stocks and as the local market rises, Japanese investor confidence also increases. This means more capital is allocated offshore, which further weakens the yen. What is also helping investor confidence levels is a more positive outlook for the US and eurozone economies than was the case six months ago.
While global credit markets have improved since the start of the year, the differential between Japan's 30-year swap spread to the 30-year government bond has widened, this while long-term US and eurozone swap spreads have declined. As the swap spread has widened in Japan the yen has declined.
In the view of Grace, there is likely to be a limit to near-term yen weakness for two reasons. Firstly, real yields in the US and the eurozone remain negative, meaning there is little incentive for Japanese fixed income managers to invest significant amounts of capital offshore, especially given the associated currency risk.
Secondly, Grace suggests Japan's real exchange rate is not particularly high, as at current levels it is only about 2% above its 15-year average.
Grace has adjusted forecasts for the yen, expecting end of quarter rates for the USD/JPY of 85.00 in June, 90.00 in September and 92.00 in December. For the AUD/JPY Grace is now forecasting end quarter rates of 91.80 in June, 97.20 in September and 100.28 in December.
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