JPY rally yet to reach old-age. The yen has had an impressive rally in 2016 but we think there is more to go. To start with, the rally is still young. The yen is rarely a “middle of the pack” currency, historically alternating between consistent under or outperformance versus the rest of G10 FX. So far this year the yen is the best performing DM currency, but the duration of this outperformance is well below the typical duration of strengthening episodes in the past. Once the JPY becomes a top-3 performer it has historically held this rank for an average of at least 17 months, suggesting plenty of scope for strength until the yen rally dies of “old age”.
Speculators not driving JPY either. We don’t believe positioning is a constraint to more JPY strength either. While the market consensus has shifted from bearishness since the start of the year, it is onshore Japanese investors that have been driving the price action rather than London or NY. The most striking evidence of this phenomenon is a highfrequency analysis of yen price action, which shows that the entirety of the USD/JPY down move since the peak in 2015 has taken place during the Tokyo timezone. Interestingly, Tokyo traders were neutral for the JPY during the Abenomics-inspired rally in 2013 and 2014. It is the structural shift in Japanese flows that began in mid-2015 that have been the primary driver of the JPY turn.
All hail hedging flows. What is the shift in flow that has taken place since the start of the year? Data on hedging flows are hard to come by, but demand for hedging FX exposure by the Japanese has arguably driven the bulk of the move. One financial market measure that is sensitive to hedging demand is the short-dated cross currency basis and this is currently running at multi-year wides. The basis is also sensitive to recent regulatory change in the US money market industry as well as other factors however, so we run a regression of the 1-year USDJPY cross currency basis on a number of related explanatory factors to isolate the effect of hedging demand. We find that the “hedging” component of cross-currency basis is also running at record highs, and conclude that hedging demand remains at a record high.
BoJ policy bullish JPY too. Beyond flows it is the shift in the Bank of Japan’s ability to influence real rates since the start of the year that has also driven yen strength. The new policy framework announced last week is effectively an acknowledgment of the bank’s loss of control of real rates, with the BoJ now targeting 10-year nominal yields and prioritizing bank profitability over the money supply and inflation expectations. Interestingly the correlation between the JPY and JGB 10-year rates has already collapsed to zero, confirming that the new BoJ policy target is not a strong driver of the currency. We worry that the shift to targeting back-end nominal rates exposes the BoJ to self-fulfilling tightening, with a negative shock precipitating additional JGB and JPY demand from onshore investors in turn forcing the BoJ to reduce the pace of JGB purchases to defend the nominal yield target but further tightening policy in the process.
Watch out for the value investor. Amid the structural shift in flow and change in BoJ policy approach it is interesting that China has emerged as a new buyer of JGBs since the start of the year with Chinese purchases of JGBs running at record highs. Portfolio flow data don’t provide information on the identity of the buyer, but a simple error-correction model of China’s FX reserve composition points to a rising share of JPY in the country’s reserves. With the JPY still cheap on our purchasing power parity metrics (USD/JPY fair value at 90) and Japanese 2-year real yields the third highest in G10 when deflated by consensus 2017 inflation, the sponsorship towards yen assets may be broadening beyond local investors. Indeed the proportion of foreign JGB ownership has risen to a new post-crisis high this year.
Political risks galore in Q4. Japan aside both the USD and EUR are burdened by significant political risks over the remainder of the year. The Italian referendum, Portugal’s market access, Spanish government formation, the second Greek program review, Merkel’s fourth leadership bid and the US election stand out as significant political risks on either side of the Atlantic. We would expect surprise outcomes in any to be negative for risk appetite and to disproportionately favour the JPY against either currency. On the central bank front we expect both the ECB and Fed to refrain from policy change until December at the earliest, leaving a two month window of central bank inactivity that allows JPY-positive flows to thrive.
Bringing it all together we like selling both USD/JPY and EUR/JPY to the end of the year targeting the low 90s and 100s, respectively.
Copyright © 2016 DB, eFXnews™
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