Our house view of JPY is a modest strengthening against the dollar towards year-end.
A positive rebound in the global backdrop for the second half of the year, along with an expected domestic growth pick-up, should underpin the currency rally, while the USD strength gradually fades.
However, both varying risk sentiment throughout the year and dovish communication from the Bank of Japan will keep the currency range-bound in our view, which is why we have revised up our Q4 point forecast in USDJPY relative to our previous call of 105. We also expect EURUSD strength by the end of 2020 to outpace JPY gains against the US dollar, implying positive prospects for EURJPY by year-end.
A global and domestic economic rebound should support consumption-driven inflation momentum, despite tax hike.
In our 2020 outlook, we expected global growth to have bottomed out in 2019 and a modest recovery over the course of the year. Our base case assumes the pace of the outbreak will peak by end of Q1 or early Q2. This allows for a V-shaped growth rebound in H2, driven by asymmetric stimulus worldwide, with Asian countries easing more aggressively.
The coronavirus outbreak in China in mid-January has shifted the global 2020 outlook in an unknown manner.
Conditional on this scenario, positive external demand growth relative to 2019 should lead to consumption-driven growth in Japan by the second half of the year. Prior to the coronavirus outbreak, the IMF had revised up its growth forecast for Japan to 0.7% in 2020, from 0.5% in October; while the BoJ upgraded its growth outlook to 0.9% from 0.7%.
Concerns about both the lagged effects of a consumption tax hike in October and the economic toll from coronavirus in China remain risks to the Japanese growth outlook. Despite countermeasures to offset the negative consumption effects of the tax hike, the 6.3% QoQ annualised GDP contraction in Q4 was worse than the expected 3.8% fall, hinting towards a potentially slower recovery in the following months.
Regarding the coronavirus hit, risks from the tourism sector are limited since Chinese inbound consumption represents just 0.8% of Japanese GDP as of 2019.
The overall macroeconomic impact remains unclear since extended supply and demand shocks from Japan´s main trading partner may curtail Japanese consumer spending further.
FISCAL SUPPORT STEPS IN TO REPLACE ACTIVE MONETARY POLICY
The main argument for the growth outlook this year rests on the fiscal stimulus package introduced by the government in December 2019, as a response to recent natural disasters and the risk of an economic downturn.
The centerpiece of the package is public works, since 71% of the ¥13.2 trillion in the fiscal plan is intended for direct spending by the central and local governments, while the remaining is to be spent via the Fiscal Investment and Loan Program.
The growing likelihood of a recession in Q1 could put pressure on Prime Minister Shinzo Abe’s administration to consider yet extra spending to bail the economy from prolonged consumption effects of the October’s tax hike and potential damage from the coronavirus outbreak.
Although this might prove controversial given the extremely high Japanese debt-to-GDP ratio, over 200% as of 2019, we believe the fiscal policy will undertake a more active role on economic stimulus, after a prolonged period of negative interest rates in the Japanese economy.
In addition, the Olympic Games to be hosted in Tokyo in the summer will support consumption, likely offsetting any negative impact from ending temporary tax hike countermeasures.
YIELD-CURVE CONTROL POLICY ADDS A LEG OF SUPPORT TO JPY
The shape of the Japanese sovereign curve is of high importance for JPY due to it being an explicit objective of BOJ monetary policy.
In 2016, the BoJ introduced a 0% target for local bond yields as downside pressure on yields kept setting the tone for Japan´s structurally low inflation and inflation expectations.
The negative correlation between 10Y JGB yields and JPY strength is a particularly useful tool to look into potential currency scenarios.
This means that, with yields already below target on the back of heightened uncertainty in financial markets, there is a limited room for the BoJ to extend the pace of its asset purchases of government bonds. Provided that relatively stable yields around the target is central in BoJ’s ability to anchor inflation expectations, commitment to push yields towards the 0% benchmark exerts upside pressure on the JPY in the medium-to-long run, while creating conditions for reasonably low volatility in the currency outlook.
Chart: With yield-curve control dominating 10Y yields around the 0% target, the scope for volatility in JPY is likely to remain limited.
The relatively high control of the Japanese central bank over the yield curve is a dominant feature in the narrative of the currency. With the BoJ holding almost half of the government’s outstanding debt, estimates show that, on average, around 90% of the decline in yields –partly driving the currency weakness- is due to the ´stock effect´ of BoJ´s large bond holdings.
Bloomberg estimates also show, however, that inertial portfolio dynamics will contribute to a reduction in BoJ´s holdings around mid-year, as redemptions are set to outpace the current trend of asset purchases.
The BoJ could continue expanding its balance sheet by increasing asset purchases in light of impending risks to the growth outlook. In turn, we think the bank is more likely to prevent a further plummeting in the bond market by rolling the current pace of asset purchases, which would lead to a de facto tightening of quantitative easing as per an implicitly shrunk balance sheet. Instead, the BoJ might continue signaling support through extended forward guidance.
While market expectations for further monetary accommodation may not be met, BoJ communication will fight any large JPY appreciation.
After a 2% surge in the yen over a matter of weeks, USDJPY is trading at the highest levels since late 2018, while markets are still pricing in a full rate cut over the next year. This was partly due to poor economic data and beliefs that the slowdown in China would push Japan’s economy into recession. Under our view that the BoJ will avoid taking rates into further negative territory as per the current macro outlook and the potential side damage to the financial system, there is good potential for a JPY rally back down toward the 108 area.
All in all, while reduced global uncertainty and BoJ communication should exert downward pressures on JPY this year, a mildly positive macroeconomic backdrop supported by fiscal stimulus and tighter than expected monetary policy tools are likely to boost the currency outlook.
However, BOJ tolerance for rapid and significant currency appreciation may be limited. We consider that the multi-year high USDJPY 100 level could be a critical threshold for policy action, beyond which the likelihood of a 10 basis point interest rate cut is high.
We assess the balance of these currency dynamics to be relatively offsetting, rendering our JPY forecast practically flat for the year.
Risks to this outlook remain in the shape of a smaller output growth gap on the back of limited consumption responsiveness to fiscal stimulus, and the prospect of an expansion in monetary support to growth.
Author: Olivia Alvarez Mendez, FX Market Analyst at Monex Europe.