The USDJPY pair has remained broadly range-bound after central banks aggressively intervened to stabilise financial markets from the sharp moves triggered by the outbreak of the pandemic. The pair’s range during the onset of the virus widened to nearly 10% between the end of February and mid- March. USDJPY volatility has since subsided, with the range falling to a maximum of 3.5% after April to date.
The volatility in JPY is muted compared to the ranges the G10 currencies have traded in against the dollar in the aftermath of the March shock, which sits around 9.6% on average – excluding the yen. The Australian dollar and the Swiss franc’s ranges sit at extreme ends of 18.1% and 4.4% respectively. Compared to historical standards, the yen has also traded in a relatively narrow range with respect to other periods of major recession risks worldwide.
Looking forward, we would expect the yen to continue trending to the upside against the dollar, while the trading ranges remain tight.
Chart: USDJPY has traded in a muted range amid the coronavirus shock relative to historic volatility.
The relatively subdued yen volatility and its resistance to strengthen to a large extent amid heightened uncertainty has gained the attention of investors and analysts. As per the sharp narrowing of the yield spread between Japanese and US bonds following the Fed´s aggressive policy easing stint, one would have expected JPY to gain ground against the greenback at a faster pace. The spread between Treasuries and JGBs 2-year yield is at its lowest level in almost a decade while the 10-year gap is narrower than ever before. The front-loaded reduction of the yield differential makes a particular case for further JPY strength, especially since the dollar has broadly weakened against the G10 currency board. However, shifting conditions in market sentiment along with markedly accommodative forward guidance by the BoJ and a bleak Japanese economic outlook keeps preventing the currency from lifting off.
Chart: Aggressive monetary easing have narrowed the UST-JGB yield to multi-year lows
Monetary policy sets the tone for a range-bound currency
Monetary policy sets a strong milestone for JPY price action, since the currency often trades as a powerful hedge against global economic and financial risks. Even when varying risk-on/risk-off waves have shaken markets over the last months, the rather soft moves in the yen broadly answers to the BoJ´s fine-tuned management of financial stability and its extensively accommodative policy stance.
So far, the central bank has undertaken action in three main areas:
Firstly: it strengthened the forward guidance on ultra-low interest rates through at least 2023, following previous hints by the Fed on a potentially longer-than-expected horizon for policy normalization. The particular linkage to Fed guidance likely signals some attention into unwarranted yield spread narrowing and excessive currency appreciation.
Secondly: the BoJ has stepped up the size of quantitative easing, while reinforcing the 10-year yield control policy anchored to the 0% cap. The BoJ dropped the ¥80tn limit for annual bond purchases for an open-ended framework, in line with increased debt issuance by the government. Even though the pace of the purchases hasn´t overstepped the previous ceiling, the introduction of unlimited QE – matched only by the Fed – sets the tone for an extensively accommodative policy stance. Further considerations on the resulting slope of the yield curves and its implications for the currency are discussed below.
Thirdly: the BoJ increased the funding mechanisms to the private sector, in order to guarantee low-cost access to credit provision from corporate, businesses and households. As part of these operations, the BoJ enhanced the program for purchases of commercial paper and corporate bonds, currently at the ¥2tn and ¥3tn caps respectively, taking the upper limit on additional purchases until March 2021 to an amount outstanding of ¥7,5tn on each asset. In addition, the bank also aims at lowering risk premia of exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs), for which it raised the annual pace of purchases to ¥6tn and ¥90bn, with an upper limit of ¥12tn and ¥180bn respectively. Finally, the BoJ also launched two programmes of special loans to facilitate financing in response to Covid-19, totaling some ¥90tn. One of these funding-provision schemes is directed at financial institutions which lend to SMEs, and it’s directly tied to a government program to exempt guarantee fees and interest payments.
BoJ Governor Haruhiko Kuroda emphasised the Bank’s firm stance regarding additional easing as necessary, depending on Covid-19 developments. However, we believe that monetary policy is now in a position to adopt a ‘wait and see’ approach as an extensive set of tools has been already enacted.
With negative interest rates, unlimited QE and various channels of liquidity provision in place, the BoJ’s options for additional easing that could prove effective from a cost-benefit perspective have practically been exhausted. In particular, we think the BoJ will be keen to avoid taking rates deeper into negative territory unless it is faced with major yen appreciation, as doing so could drastically increase stresses on the financial system. On the prospects of policy normalization, however, the central bank faces a long road. Despite the broadly accommodative stance of monetary policy, there is at least one policy gap from which JPY could grab some support. A sharp steepening in Japan´s yield curve could draw international interest as other central banks vow on the desired flattening of domestic yield curves. A bear steepening of the yield curve refers to the steepening caused by long-term yields increasing at a faster rate than short-term rates and it´s usually suggestive of rising inflationary expectations.
The move, triggered by excess supply of long-term debt issued by the government amid the coronavirus crisis, could divert bond demand in favor of short-term maturities, as projected real yields in the back-end of the curve decline due to rising inflation expectations. This, in turn, adds upwards pressure on the currency.
Studies on the correlation between bear steepening of the yield curve and the FX market show that even though the relationship varies across time and currencies, there is a strong positive relationship. This argument grabs special attention since the Fed is increasingly expected to undertake a Japan-like YCC approach to guarantee a flatter -growth-boosting- yield curve. In turn, the BoJ has gradually reduced purchases of super longs, partly to mitigate the side-effects of prolonged quantitative easing. In particular, the bank might choose not to increase its purchases of 25-year and longer debt because of concerns about the risks posed to life insurers and pension funds, which rely on yields on long-dated debt. Higher long-term yields could also help underpin relatively stable inflation expectations.
Chart: BoJ has been cutting the buying of super-long bonds faster than other tenors
Deflation risks abound in Japan’s macroeconomic outlook
While the BoJ has already abandoned expectations that inflation reaches the 2% annual rate anytime soon, the focus is now placed on whether or not the economic recovery will be rapid enough to avert deflation.
The Japanese economy is in a severe situation due to the impact of Covid-19, both domestically and abroad.
The IMF revised up the size of the expected Japanese recession in 2020 to 5.8%. The BoJ´s latest projections indicate a 3%-5% contraction in the fiscal year through to March 2021, while the bank is likely to cut growth forecasts further in the July policy meeting.
On the supply side, exports and industrial production have dropped substantially, while business sentiment remains weak. The Tankan large manufacturing index plunged to -34 in Q2, from -8 in Q1; while the large non-manufacturing index collapsed to -17 in Q2, from +8 in Q1. The GDP signal from this gauge suggests downside risks to the 6%-8% contraction forecast in Q2, following the 1.9% dip in Q1. Signals from the labor market also lean to a worse-than-expected outlook, despite the relative resilience in employment thanks to the Japanese distinct furlough system.
Despite a sharp deterioration in economic activity, the unemployment rate in Japan rose only moderately by 0.1pp in April to 2.6%, in sharp contrast to the surge in the US and other major economies.
The Japanese employment adjustment mechanisms traditionally prioritizes securing employment over wages, with companies being legally bound to pay workers an average of at least 60% of their wage as a leave allowance.
The unprecedented increase in the number of furloughed workers -who are still employed but not working- has largely contributed to the low unemployment record, which otherwise would have jumped to over 11% in April according to Goldman Sachs estimates.
In terms of compensation, special cash disbursements of ¥100k per person on the government´s account have also underpinned disposable income. However, both state-of-emergency rules and broad uncertainty have diverted consumption spending into ramping up saving intentions. GS foresees April-June and July-September savings rates at 20% and 17% respectively, from an average rate of 5.4% in the 2019 fiscal year.
Our forecast for JPY remains supportive of a positive yet small appreciation towards the end of the year. In our view, JPY´s attractiveness as a heaven asset will linger for a while longer as economic uncertainty abounds in the global landscape and economic recovery takes a slower pace than previously foreseen. The yen could also find some support in the mounting pressure to other central banks into committing to similar yield control mechanisms as the Bank of Japan’s, especially since the oversized debt issuance raises pressure on back-end yields. The Federal Reserve is particularly likely to take this road, at a time were the Treasuries-JGBs yield spread is already at multi-year lows across expiry dates. The BoJ’s apparent intentions of allowing some back-end steepening into the JGBs yield curve add to this argument. However, the extent to which the currency is likely to appreciate is relatively muted.
The broadly accommodative stance and forward guidance by the BoJ, along with its linkage to the Fed guidelines and fine-tuned management of financial conditions, make the case for a rather subdued transmission into the foreign exchange market.
Author: Olivia Alvarez Mendez, FX Market Analyst