News & Analysis

The Japanese yen has broadly met our mid-year expectations of a cautious recovery against the dollar in the second half of this year. Despite rallying against the greenback, the yen has underperformed against other G10 currencies in the aftermath of the pandemic to date, with the trade-weighted exchange rate having weakened since the May surge.

This is largely due to an improvement in risk appetite amid groundbreaking vaccine developments, which is weighing on the safe-haven appeal of the Japanese yen, even as the US dollar broadly weakens. While the recovery in risk appetite has capped any additional JPY gains, the currency is also virtually bound by the crucial level of ¥100/USD. Markets anticipate that at this level, authorities will intervene to some degree, which places a further headwind to JPY gains. Finally, the third wave of Covid infections is poised to delay the economic recovery.

With growth differentials still a strong dynamic in markets, challenges in the path to immunisation has weighed further on the yen’s rally.


JPY rallied against the dollar, yet underperformed against other major peers

With that in mind, however, we continue to believe that the currency will extend its smooth rally against the dollar over the coming year. We have revised up out yen forecast relative to that printed in the USD outlook due to a fast downtrend in the dollar than previously expected. Our expectation of further JPY strength is due to our outlook for Japan’s economic recovery in 2021, while massive economic stimulus and fresh reforms gain traction in the country.  Additionally, amid an environment of negative real yields in major economies, the Bank of Japan’s loose monetary stance is set to become less of a factor limiting the yen’s strength, with the currency likely to continue losing its appeal as a funding currency relative to USD and EUR. A cyclical rally in Japanese equities amid ample fiscal stimulus is also poised to support the currency next year, while investors not only praise the magnitude of the government´s aid, but its quality too. Caveats to this view lie in the underlying risks to the domestic economic outlook, with the potentially lasting impact of the pandemic deepening secular stagnation in Japan.



The narrowing spread between US and Japanese real yields has been the theme for most of 2020 and is poised to continue into 2021. With the Fed taking its interest rate to the effective lower bound at a time when deflation dynamics abound in Japan, domestic real returns in Japan have already exceeded their US peers across the whole of the yield curve. Moreover, the shift in the Fed´s policy reaction function to a more tolerant stance on inflation overshooting sets the tone for a persistent compression in real yield differentials in the years ahead. A narrower gap in real yields provides private investors with increased incentives to hedge Japanese assets, while fixed income and/or carry funding outflows become less attractive in comparison. The historically strong correlation between the US-Japan 2-year spread and the USDJPY pair suggests the currency might be currently undervalued from this perspective. While this relationship may prove insufficient to assess the short-term dynamics of JPY, we believe it will remain the strongest underlying factor in the medium-term trend of appreciation expected in our currency outlook.


US-Japan 2Y real yield spread hints of a mild yen undervaluation

The substantial surge in foreign asset investment by domestic investors in recent years has made the USDJPY currency pair more sensitive to portfolio reallocation flows. Most notably, Japan’s Government Pension Investment Fund (GPIF) accounts for a huge proportion of these portfolio-driven currency moves, with over 30% of their total assets being invested abroad. According to Goldman Sachs estimates, the GPIF´s foreign bond allocation is currently underweight relative to the lower bound of the target range. Following solid domestic equity gains throughout the year after the Q1 crash, the GPIF may opt to reallocate equity holdings and profits towards foreign bond markets in order for its portfolio to remain within its current confines. Although foreign investment outflows have slowed compared to the beginning of the year, portfolio reallocations under the remit of diversification could play a major role in the yen price action. This provides the government with a level of control over FX markets as the USDJPY approaches the sensitive ¥100 barrier, as “unintended” currency moves from fine-tuned wealth management policies can result – this is a form of backdoor currency intervention that can limit the extent to which the yen can rally in 2021.



Beyond the risk/return notion, the fast pace of the economic recovery along with favourable management of the pandemic should be positive drivers of JPY price action in the year ahead. Japan is in a strong position to outperform most of its developed peers in lifting the economy to pre-pandemic levels on the back of a prompt combination of monetary and fiscal stimulus. Decisive steps by the BoJ towards corporate debt financing have cleared out crucial credit strains, while adherence to negative rates and yield capping combined sets the tone for an ample accommodative policy in the coming quarters. Focus on productivity-enhancing fiscal investment, along with core reforms to the Abenomics toolbox, are the centrepiece of Japan’s economic performance in the Suga era. Critically, better management of the coronavirus boosted by a promising vaccination agenda should pave the way for a faster lifting of restrictions and economic recovery in comparison to other G10 economies. According to the Covid Resilience Ranking by Bloomberg, Japan holds the 7th best pandemic status worldwide.

The Japanese economic recovery in Q3 exceeded economists’ expectations of a 4.4% expansion to print a preliminary figure of 5.0% QoQ, which was revised up to 5.3% in subsequent readings.

The sharp upward revision of GDP growth in Q3 underlines the strong rebound of the Japanese economy, leaving output 3.92 percentage points below the pre-pandemic levels.

In relative terms, the growth shortfall is only marginally larger than the US one, which is some 3.48% below the Q4 2019 GDP levels. By contrast, the speed of Japan’s recovery outpaces that of the EU, the UK and other advanced economies. Private consumption has been the main contributor to the upward revision in GDP growth as it rose 5.1% QoQ in Q3. With a 3.6% MoM rise in core household spending in October pushing private consumption growth to a 13F-month high in the same month, the rebound in private consumption is set to continue in Q4 despite the surge in coronavirus infections. Capital spending remains strongly supported by favourable credit conditions. Capital goods shipments, which account for around half of business investment, surged to its highest monthly pace on record at 14.6% in October, securing a 9% QoQ rise in machinery investment in Q4 should the November and December levels remain flat. Operating profits nearly recovered in full from the 41.9% sequential fall in Q2, with a 41.4% QoQ rise in Q3 leaving profits at a -39.0% yearly decline from a -64.8% YoY drop earlier.


Japan follows the US recovery as it outperforms European peers

Looking ahead, the economic recovery is poised to be strong next year as vaccination plans speed up in Q2. The Tankan Q4 economic survey bolsters the view that Japan will recover quickly after the third wave of infections has passed, with output likely to be back at pre-virus levels in mid-2021. Capital investment is set to increase from both the cyclical recovery and tax incentives related to software investment and supply chain realignment. Consumer spending will remain strongly supported by saving buffers boosted by government programmes, offsetting the recent decline in total earnings. Surveyed employments conditions hint at a deterioration in the unemployment rate, which is set to peak in Q1, although increasing overtime hours and rebounding employment after that should pave the way for steady wage growth looking forward. Public investment is set to remain high, with a third round of fiscal aid, matching supplementary budgets from April and May, already on the table. Public works investments are also likely to uptrend ahead of the Lower House elections taking place in autumn 2021.

In the immediate future, however, the third wave of the virus will slow down the economic recovery. The current surge of Covid-19 is the most severe to date in Japan, with new daily infections, hospitalised patients and deaths reaching record high since the pandemic’s outbreak in March. As a result, the Japanese government recently suspended the ´Go To Travel´ campaign from December 28th to January 11th, a program intended to boost national tourism by halving travel costs within the country. As such, spending on services could continue to be sluggish in the following months. However, the extension of the ´Go To Travel´ campaign until June in the latest fiscal package along with other financing measures oriented towards the labour market would prevent a further contraction in private consumption.

Flash PMI readings in December show a marginally negative impact on services demand, while the Nikkei 225 equity index has steadily risen over 16% since the end of October.


Third wave of the virus is the most lethal to date in Japan



Crucially, the Japanese government continues to prioritise the economic recovery amid the third wave and is only responding with mild restrictions to activity. While other neighbor countries have pursued drastic measures towards elimination of the virus – like Australia, New Zealand, China and Taiwan – Japan has been relatively successful in living with the virus as a way to mitigate the economic impact. The government has avoided the imposition of compulsory lockdown measures, while respecting voluntary business closures. The Japanese model to fighting the virus has centered on a cluster-based tracing approach, which aims to find the source of infections and contain the spread thereafter. This backward-looking tracing allowed the country to maintain the reproduction rate of the virus close to one until just recently, due to clusters becoming more varied and harder to track and control. While infections in the hardest-hit prefectures are starting to show signals of peaking, the loosely controlled health situation poses downside risks to our strong economic outlook for the Japanese economy in 2021.


Japan leads the race of Covid immunisation from a relatively better starting point

Source: Launch & Scale Speedometer. Updated: December 18th, 2020.


Recent vaccine developments are good news for Japan, although a significant lack of trust in vaccine safety may become a serious issue going forward. The government has preordered 290 million doses between Pfizer, AstraZeneca and Moderna vaccines, which are enough to inoculate the 126-million population in time for the Olympics in July. However, Japanese authorities will have to overcome substantially low confidence in the vaccine by the public, with fewer than 10% of survey respondents strongly reliant on the safety of the drug, according to a study by the Bristish journal the Lancet. Similarly, the international research group Ipsos found that 69% of people in Japan were somewhat willing to get the vaccine in October, down from 75% in August and just slightly above the 64% score in the US. Japanese authorities have tried to reassure the public regarding the vaccine safety, guaranteeing coverage of medical costs and disability allowances in case of serious side effects on top of cost-free vaccine provision. However, critically low levels of public trust over the coronavirus policy might weigh on the immunisation agenda, posing significant risks to the expected economic rebound and yen rally.



Looking ahead, the lasting impact of the pandemic on the secularly stagnant Japanese rate of growth is anybody´s guess. It seems likely, on one hand, that Covid-19 may have killed ´Japanification´ by breaking the traditionally neutral impact of sustained public spending and monetary co-ordination on domestic growth. In fact, the targeted fiscal stimulus may play as a strong factor this time around, since not only the quantity but the quality of the public investment is set to enhance supply and productivity levels. As a result, Japan could take a top position among its major peers for the next decade, having done a relatively better job on public health management and having seen the smallest decline in its productivity growth rate since 2003. On the other hand, however, failure to tackle the pandemic accordingly will offset the government’s efforts to protect the business sector and labour market, while reducing the boosting effects from monetary and fiscal response.

We therefore remain cautious in our view to a successful immunisation path leading to a sharp economic rebound going forward.

Conversely, even though we keep a strong conviction on a surging yen over the next 12 months, we expect the currency to rally on a moderate pace, akin to that seen in the latter stages of 2020.


Author: Olivia Alvarez Mendez



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