- Japan's CPI less fresh food fell 0.4% in the year to the end of May
- USDJPY hardly moved on the news, it seems only intervention will do that
- JPY's rally needs to reverse to give any credibility to the BoJ's 2% inflation forecast
- Unless the exchange rate weakens significantly, another cut to the outlook is likely
By Max McKegg
Today’s inflation update from Japan illustrates the deep hole the Bank of Japan finds itself in and the reason the FX market is holding Governor Haruhiko Kuroda’s feet to the fire, searching for his pain threshold on USDJPY.
The numbers should have weakened the JPY because of the increased chance the Bank will expand its QE program. But USDJPY
hardly moved: it seems only determined intervention is going to do that.
Game plan ... Roger Federer knows what to do when the ball's in his court but what's BoJ Governor Haruhiko Kuroda's going to do. Photo: iStock
The inflation benchmark, the Consumer Price Index less fresh food, fell 0.4% in the year ending May. The core rate, which excludes energy prices, was positive 0.6%. And things won’t get any better next month: the Tokyo CPI as at the end of June came in at minus 0.5% year on year.
The reason the stubborn decline in USDJPY matters is illustrated in the chart below from Credit Suisse. A rising yen is lowering import prices, and in the months to come even the core CPI will slip into deflation, a nightmare scenario for the Bank of Japan.
Source: Credit Suisse
A reversal of the yen’s rally would seem to be essential to give any credibility to the Bank of Japan’s forecast that inflation will hit the 2% target during fiscal 2017. But not even a return to risk-on conditions in recent days has had much impact on USDJPY, and it seems the onus is on the Bank to get the ball rolling via intervention.
The problem is exchange rate policy is the province of the Ministry of Finance and for it, global politics take precedence over inflation targeting. The G7 frowns on currency manipulation, and US Treasury Secretary Jacob Lew said earlier this week that for intervention to be justified, “there has to be a reason based on disorderly markets”. He made it clear that just because an exchange rate is rising contrary to a central bank’s wishes doesn’t mean the market is disorderly.
It’s a long time since the Ministry of Finance gave the BoJ the green light to intervene in USDJPY, as shown by the blue arrows in this chart (click to enlarge). Many traders thought the Bank caused the 200-pip rally off 99.00 shortly after the Brexit result, but figures released yesterday by the Ministry showed there has been no change in FX reserves.
Nevertheless, it would be a mistake to think G7 disapproval will tie official hands indefinitely. Indeed, it is likely the BoJ is waiting, jaws wide open, to bite the heads off any traders who push USDJPY back under 100.
It’s not only speculators who have been buying the JPY. Despite the miniscule yields on offer, foreign investors have been increasing their holdings of Japanese government bonds (JGBs) in recent months. Those that got in early have seen some spectacular returns: a combination of falling bond yields (rising prices) and a decline in USDJPY, has produced a return of almost 80% on the 40-year JGB for a USD-based investor this year.
In GBP terms, it has been an almost double-your-money trade. And with rate differentials narrow at the short end of yield curves, foreign investors who didn’t want to take on currency risk have been able to buy long JGBs, roll over short-dated hedges, and still earn a return close to 40%. Who says you can’t make money in bonds at the current yield levels?
Source: Wall Street Journal
Of course, foreign investors have had to compete with the Bank of Japan, who is buying JGBs at a hectic pace in an effort to expand the monetary base. The central bank’s balance sheet has already reached the equivalent of 80% of Japan’s GDP and it is projected to increase a further 16% each year until someone calls time out on QE. In comparison, the US Federal Reserve’s balance sheet is 25% of GDP.
Today’s inflation update sets the scene for the Bank of Japan’s quarterly Outlook Report, set for release when the policymaking board holds its next meeting on July 28. The report will include updated economic forecasts, and unless the exchange rate weakens significantly in the meantime, another cut to the inflation outlook is likely, further damaging the Bank’s credibility.
The ball’s in your court Mr Kuroda.
– Edited by Gayle Bryant
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.