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Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 25 November 2016 at 1:05 GMT

Latest inflation numbers offer Bank of Japan a glimmer of hope

Managing Director / Technical Research Limited
New Zealand
  • Inflation numbers have ticked slightly higher in Japan
  • Exchange rate depreciation will gather steam as the rate differential widens
  • Bond futures suggest BoJ will give way on yield curve control
  • The BoJ governor is deluded if he thinks he can hold back global market forces

By Max McKegg

On Friday morning the latest inflation numbers for Japan were released. The Bank of Japan’s benchmark (the Consumer Price Index less fresh food) declined 0.4% over the year ending October 31, a slight improvement on the previous month’s –0.5%. The core reading, excluding both fresh food and energy, came in at 0.2% up from zero.

On their own, these numbers weren’t good enough to push USDJPY any higher but, when seen in the context of the recent sharp decline in Japan’s exchange rate, the central bank might just about be able to see some light at the end of the tunnel.

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 Japan's core inflation measure has edged higher, and there is a good chance that it will land in positive territory next year. Photo: iStock

Japan’s inflation problem is best illustrated in the chart shown below. The BoJ’s benchmark is the CPI (all items less fresh food), which is the black line on the chart. The graph splits the inflation rate into two components, the first being “Items other than energy” (as known as core) which has been slipping, in part due to the appreciation of the exchange rate, but remains positive. The second is “energy”, and with oil prices still below where they were this time last year, the negative contribution from this component has been sufficient to drag the total CPI number under zero.

But oil prices bottomed in January and have been on a steady rise since, meaning that the red bars will soon move back up to the zero line at least. At the same time the recent sharp reversal in USDJPY will start to have a positive impact on the core component as import prices rises feed through. All up, there is a good chance the benchmark index will crawl back into positive territory early next year.

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Source: Bank of Japan

But Bank of Japan Governor Haruhiko Kuroda and his colleagues won’t count their chickens until they’re hatched, having made that mistake on too many occasions in the past.

That means current monetary policy centred on “yield curve control” will remain in place for some time yet, especially as it seems to have been very effective in weakening the exchange rate. The FX market is now taking its cue from medium term yield spreads rather than those at the short end of the curve, and with the BoJ holding the 10-year JGB rate close to 0% while global markets sell off, the yen is declining as rate differentials widen, especially in relation to the US.

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 Source: ANZ Bank

But since 1996, the correlation between US and Japanese 10 year bond yields has been 0.85, so the governor is as deluded as King Canute if he thinks he can hold back the tide of global market forces (as Swiss National Bank President Thomas Jordan found out with his EURCHF peg). Kuroda should know that you can control the price of an item or the quantity, but not both at the same time. Yet the central bank’s stated policy is to set the 10-year yield at zero percent while maintaining the previous rate of bond purchases.

In reality, if yields continue to rise in the US, the BoJ will have to choose whether to remove the limit on purchases or raise the yield target. The former option will be pursued in the short term, even though the bank’s balance sheet is already the equivalent of more than of 80% of GDP and is giving the Swiss National Bank a run for its money (the Federal Reserve’s balance sheet topped out at 25% of GDP).

That won’t stop Kuroda. He will let the balance sheet go to 100% of GDP - or more - if that’s what needed to “drastically convert the deflationary mindset”, even at the risk of letting the inflation-genie out of the bottle. Indeed, frustrated by years of failure, he has already issued an “inflation over-shooting commitment”.

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Source: Swiss National Bank

We saw evidence of the BoJ’s determination last week when they offered to buy unlimited quantities of 2-5 year maturity bonds at a set price. Sellers were scared off and the market stabilised without the bank actually having to write out any cheques.

In the meantime, the US versus Japan medium term yield spread has expanded to a five year high and the the FX market has taken USDJPY along for the ride. This is unexpected good news for the BoJ. Like everyone else they were surprised when the cross declined after negative rates were introduced to the short end of the yield curve last January. It seems a rise in the medium term interest rate differential is what the market was waiting for (as in the case of EURUSD).

However it would be mistake to bet the BoJ will continue to stand in the market if the US bond market selloff gathers momentum. Indeed the the JGB futures chart shown below (please lick to enlarge) suggests traders expect them to raise the yield target instead.

A clear head and shoulders pattern has formed with a decisive neckline break. The current price is equivalent to a yield a touch over zero. If achieved, the head and shoulders target would see the price/yield back to January levels, just before negative rates were introduced.

JGB futures chart
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Source: Metastock
 
Bond traders are taking their cue from guidance that the BoJ is targeting real rather than nominal interest rates, suggesting nominal rates will be allowed to rise in line with inflation expectations. The trouble is, the process of inflation expectation formation in Japan is “adaptive”; that is, business and consumers think current inflation is the best guide to the future and they don’t give much credence to assurances the central bank’s 2% target will be achieved.

This latest inflation update isn’t going to change that perception in a hurry but, combine it with a further extension of the USDJPY rally, and the situation would look more promising.

Analysis of USDJPY rally

USD/JPY has rallied nicely these past couple of weeks. Please see my latest analysis below.

 
Daily USDJPY chart

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Source:  ThomsonReuters 
 
Weekly  USDJPY chart  (click to expand)

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Source:  ThomsonReuters.  Create your own charts with SaxoTrader; click here to learn more. 

– Edited by Robert Ryan

For more on forex, click here.

Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.

2y
Treve Treve
superb analysis and trading forecasts these past 2 weeks on DYen Max!
2y
Patto Patto
Looks as if the market did like the inflation numbers: USDJPY up from 113.25 to 113.80
2y
brian1983 brian1983
any signs of usdjpy to correct?
2y
Max McKegg Max McKegg
Brian, in Uptrends (like USDJPY) I am constantly looking at suitable Buying opportunites and next week will be no different. I analyse and forecast all the currencies each and every trading day.
2y
Jim Earls Jim Earls
Such a large move in interest rates is a real danger, if you are long stocks or USDJPY.
2y
IL IL
bearish engulfing candle on usdjpy on 2 hours chart and I think, it is making en evening star on dayli
2y
brian1983 brian1983
i dont know. but i feel the dollar will correct next wk. italian referendum on dec 4th. though is weekend thing. the uncertainty may need to some safe haven flow of the yen n gold n hence cause usd to hv some healthy correction.
2y
brian1983 brian1983
also end nov. ppl nd to book their usd long profit n book their dec vacation
2y
brian1983 brian1983
but i am nt touching usdjpy for now till after early dec...

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