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Can the yen weaken to 130?

During the Capital Economics Annual conference I attended recently, the research house boldly predicted the Japanese yen to weaken to 130 per dollar by the end of 2017.  

Bank of Japan
Source: Bloomberg

This prompted a flurry of questions after the presentation, focusing on that bold prediction.

If that forecast was given at the start of this year, where the USD/JPY sat  at 120, investors would think reaching 130 was quite plausible. At that time, there were abundant expectations for further yen depreciation on a combination of weak growth in Japan and massive quantitative easing.

However, the JPY gained over 10% to trade below 110 against the greenback. Many were caught by surprise of the ferocious strengthening of the yen. The haven demand of the JPY was remarkably strong.

Furthermore, the Bank of Japan (BoJ) imposed negative rates on some reserves banks held within the central bank This spooked concerns about bank profitability, leading to a selloff in Japanese equities. Typically, when a central bank implements monetary easing or negative interest rate policy, the local currency will weaken sharply. In the case of Japan and the Eurozone, this has not been the case, with the yen and euro proving to be resilient.

At the same time, market participants were trimming expectations that the Federal Reserve will raise interest rates this year, as a series of weak Q1 US data filter through. The resulting USD weakness powered JPY forward.

 

BoJ holds fire but remains dovish

The BoJ maintained current policy setting at the 15-16 June meeting, in line with expectations. Governor Kuroda reiterated that JPY gains  which are not fundamentally driven are undesirable, paving the way for BoJ to intervene in the FX markets as needed. He stressed that the bank will not hesitate to expand stimulus if necessary, although he highlighted that the aim of monetary policy is not to target a certain level of exchange rate.

Ironically, the Japanese yen rallied to the highest since August 2014, breaching below 105 against the dollar. Investors seemed to be increasing their long bets on JPY, despite risks of further easing from the BoJ.

USD/JPY weekly chart on 16 June 2016
USD/JPY weekly chart on 16 June 2016

Indeed, there is room for the BoJ to do more, notwithstanding concerns that they have run out of Japanese debt to buy. The central bank now owns more than a third of all outstanding Japanese Government Bonds (JGBs) at the end of 2015, from around 15%. Other entities, including insurers, pension funds, and banks saw their share of JGBs reduced. JGB supply constraints may easily be fixed. For instance, the BoJ and Finance Ministry could cooperate to accelerate bond issuance as well as increase fiscal stimulus.

In March, the Japanese parliament approved a record budget of JPY 96.72 trillion, and a supplementary budget of up to JPY 10 trillion might be injected to stimulate growth. In addition, some large bondholders may be holding on to more debt than they need for regulatory requirements, which means that there is still room for banks, pension funds and insurers to sell JGBs to the BoJ.

Overall, BoJ certainly could step up the QQE programme to expand monetary easing, apart from going for deeper negative rates or increasing ETF purchases. This means that the bullish direction the yen is on may run out of steam. Moreover, FX intervention will also deflate bullishness.

When risk sentiments in the global markets improve, we could see an unwinding of JPY longs. Although USD/JPY reaching 130 seems like an audacious forecast for the moment, it is not exactly impossible either. 

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