Currencies: JPY--Medium-Term Risks to USD/JPY Tilted to the Upside
[Any thoughts on this Haim? - mish]
Stephen L. Jen
USD/JPY forming a medium-term bottom. Though USD/JPY could drift marginally lower to 105 in the near term, for 2005, I see USD/JPY trading toward 115.
First, a further clarification of my call. The Japanese economy is doing very well, enjoying a sustained structural recovery based on (1) grossly depreciated capital stock; (2) a generational recovery in risk-taking, and (3) corporate and other structural reforms. The surge in demand from China was clearly the trigger for this recovery. There will no doubt be risks along the way (e.g., recession scare in the US and the China Shock), and recovery will likely not be linear. But these cyclical matters should be considered in the context of a structural recovery.
My outlook for a sustained structural recovery in Japan implies that inflation expectations will rise before actual inflation rises. Given that the preconditions the BoJ has declared for ending ZIRP (zero-interest rate policy) are centered on actual inflation, this necessarily suggests that the yield curve in Japan will steepen, as the BoJ will intentionally fall behind the curve.
In this scenario, USD/JPY has the best chance of selling off in the early stages of the cyclical recovery, as capital inflows (mostly into the Nikkei) are front-loaded, in expectation of such an economic recovery. But when domestic demand actually recovers in Japan, inflation should rise and the current-account (C/A) surplus of Japan should start to decline. Add the China Shock, and USD/JPY could start drifting higher. This is why we have USD/JPY forecasts of 107 and 105 by end-Q3 and Q4 of this year, but 113 by end-2005.
My ‘multiple shadow prices’ framework revisited. Until recently, the level of USD/JPY required to clear the asset market was very different from that for the goods market. In other words, for years, the world loved Japanese goods but hated JPY assets. My personal guess is that, as recently as 2002, the market clearing price (shadow price) for Japan’s asset market was as high as 150, while that for the goods market was below 100.
In the case where there is no progress on structural reforms, domestic deflation would be sustained. Exporters face a gradually declining cost structure, which should allow them to remain competitive with a declining USD/JPY. At the same time, the quality of the balance sheets of banks would continue to deteriorate. This would make JPY assets less and less attractive, increasing the level of USD/JPY required to ‘entice’ foreign investors to buy JPY assets. The end result is that, with deflation, the two shadow prices will diverge. This helps explain why USD/JPY has been so volatile in the last decade, as spot USD/JPY varied within this wide range.
Conversely, with progress on structural reforms and on fighting deflation, inflation should gradually rise, pushing up the shadow price for the goods market and JPY assets should become more attractive over time. This should bring about a USD/JPY that is more stable over time and one that no longer experiences sustained downward pressures from a perversely competitive goods market.
Back to the real world. How does this really apply to USD/JPY at present? First, the Japanese macro data have been strong recently. Risks on the horizon are coming from the external sector: a possible growth relapse in the US (which I don’t believe will materialize) and the China Shock. With domestic demand strong, while external demand is at risk of weakening, the ‘risk-adjusted’ goods market shadow price should drift higher, corresponding to a prospective modest compression in Japan’s C/A surplus.
Second, as I mentioned above, the more the BoJ delays taking back excess liquidity in the system, the higher expected inflation would be. The implications of a further steepening in the yield curve would exacerbate the ability of the MoF to service its debt. Rekindled angst concerning Japan’s fiscal affairs could weigh on JGBs and elevate the financial shadow price of USD/JPY.
Third, there are signs that net portfolio flows into Japan may be approaching a saturation point. The overall balance of portfolio flows has been negative since April.
While there is downside risk to USD/JPY in the near term, I am more confident that USD/JPY will trade modestly higher as soon as the US reaccelerates. A month ago, I abandoned the call that USD/JPY will break below 100. From a medium-term perspective, I believe a buy-on-dips strategy on USD/JPY is more logical. |
