News & analysis

As economic and financial risks to the economy intensify, markets are looking to Japanese fiscal and monetary policy for an aggressive response.

As part of the first package of measures in reaction to increasing risks on the back of the coronavirus outbreak, the Bank of Japan helped ease liquidity conditions in the banking system by offering short-term repo operations worth of ¥500bn to banks and record ¥100,2bn purchases of exchange traded funds.

BoJ’s governor Kuroda also hinted at raising asset purchases, in a year when the net effect of QE on Japanese monetary conditions was previously set to soften somewhat, as increasing asset redemptions began to outpace new purchases.

In the fiscal front, where no policy action had been taken yet, an important adviser to Abe’s economic policy plan suggested the government should undertake a massive fiscal emergency package of at least ¥5tn to support the economy –on top of the ¥13,2tn plan released on December to counteract the negative impact of October’s tax hike.

Even though the policy reaction in Japan could be viewed as modest so far compared to other advanced or affected economies like China, the US, South Korea, Canada, Australia, and potentially the EU and some emerging markets, recent sharp market swings suggest more policy action will be taken shortly.

Fiscal policy is likely to be among the first areas of action, since the BoJ’s monetary space is fairly limited and potentially less effective given its already accommodative stance.

As part of a second round of emergency measures in response to the coronavirus outbreak, Prime Minister Shinzo Abe announced during the weekend that the government will offer interest-free loans to small and medium-sized companies facing sharp revenue drops, through fully government-owned financial institutions and other organizations.

The government also announced that the emergency package will take full shape by March, 10th, with other measures including actions to prevent the spread of the virus and to deal with economic costs from the closure of schools and the decrease in business activity.

Markets could still deem these actions insufficient considering the impending recession risks facing the Japanese economy.

JPY has strengthened nearly 9% over the last two and a half weeks to a 3½-year high, which is particularly dampening to the Japanese economy in a context of global deflationary risks.

The Nikkei equity index has fallen some 16% in the same time frame, and almost half of it has happened since last Friday, when oil prices crashed on the failure of the OPEC+ cartel to settle supply reductions.

Under the prospects of a long-lasting deceleration of oil prices – Goldman Sachs forecasted that prices could plummet by a further 30% in the following weeks-, the BoJ is now faced with an uglier picture of Japan´s structural deflationary concerns.

Speculation on the postponement of the summer Olympics in Tokyo adds to the prospects of a deeper economic recession in the future, which is now nothing but a given fact for at least the first quarter of the year. At this juncture, monetary policy is faced with the dilemma of avoiding a wider depression of current economic activity at the expense of extending long-term low inflation expectations.

This means that both a rate cut into further negative territory and an extension of asset purchases are increasingly likely, along with other targeted measures to support stability conditions in financial markets. In the context of heavily aggressive monetary policy accommodation worldwide -led by the 50 basis point cut by the Fed and the zero lower bound almost priced in by US markets-, the BoJ could otherwise risk tightening financial conditions if it were to remain little supportive.

Despite increasingly high risks of recession in Japan, plummeting bond yields around the globe and the extremely high risk-off mood in financial markets remain supportive of a further JPY appreciation in the short and medium term.

The critical 100 level for USDJPY could mark a threshold for the BoJ to prevent further currency strength by means of a heavier-than-expected monetary intervention, but under the current market price action, even that level is likely to be surpassed.

It will all hinge on whether containment efforts can shift the coronavirus spread soon enough –i.e, early Q2 at most-, and to what extent markets keep pushing for central banks action.

Prospects of a potential recovery are still hanging in the air on the back of massive global coordinated action, but both the timing and the shape of the rebound are rapidly tilting to the downside. This implies that JPY strength could remain for longer and shift only gradually towards the back end of the year.

 

JPY strength to a 3½-year high against the USD could put BoJ´s patience to the test shortly.
Japanese equities’ collapse since the coronavirus outbreak has topped third among advanced economies.
Japanese financial conditions index is about to test stress levels from recent history.

 

Author: Olivia Alvarez Mendez, FX Market Analyst at Monex Europe.