Yen’s risk-reward profile becoming more attractive

While US interest rates have already declined from their mid-June highs of 3.5%, the US dollar has not given up any of its recent gains against the yen. This is in large part because growing fears about the global economic outlook, coupled with a hawkish Fed are strong tailwinds for the US dollar. As for the yen itself, a number of domestic factors are holding it back. One of these could be renewed large purchases of foreign debt securities by Japanese pension funds and life insurers, attracted by the higher yields to be had outside Japan and/or the lack of paper left to buy domestically as the Bank of Japan (BoJ) ramps up its government-bond purchases.

These domestic hurdles are hurting the yen at a time when other sources of capital flows are not providing much support either. Japan’s current account has become more volatile since the shut-down of more than two-thirds of the country’s nuclear reactors after the 2011 Fukushima disaster and is now deteriorating because of the rise in energy import costs. Also, net foreign direct investment outflows have been accelerating since 2010.

The deterioration in the economic outlook should put a lid on interest rates globally, potentially providing a more supportive environment for the low-yielding yen going forward. In addition, the weak yen, a manifestation of the BoJ’s ultra-loose monetary stance, is becoming a hot political issue as Japanese households grow increasingly concerned about the rising cost of living. The authorities may decide at some stage to combat the yen’s sharp depreciation through intervention on the FX markets directly. But one should not exclude the possibility that the BoJ also changes its ultra-loose monetary policy under political pressure. We could also see a change in the BoJ’s goal of 2% consumer inflation after Haruhiko Kuroda steps down as BoJ governor next April.

For all these reasons, we are keeping our positive view on the Japanese yen. Our three-month projection against the USD remains at JPY132, our six-month projection at JPY126 and our 12-month projection at JPY120.

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