Japan’s QQE exhausted? Yen to rally

There were strong services and non-manufacturing PMI numbers out of the US overnight, which helped strengthen the US dollar against most currency pairs.

Japanese Yen
Source: Bloomberg

The ISM non-manufacturing PMI continued at a robust pace at 59.0. Expectations were for a 58.2, and the final number was only slightly below the 60.3 obtained in July, which was the highest reading since 2005. However, there were points for concern in the report with the employment component declining to 56.0 from 59.6 the previous month.

Considering the ADP employment numbers on Wednesday came in below consensus as well, there is a high likelihood that the non-farm payrolls release on Friday may struggle to reach the lofty consensus target of 220,000. The question then becomes, at what level does the number become a serious cause for concern? It’s quite likely that any number below 200,000 would see significant selling of US dollars. It’s worth mentioning that in recent years the August non-farm payrolls numbers has also consistently undershot consensus expectations by an average of 55,000.

The other concerning number from last night’s PMIs was the price component of the Markit Services PMI. Prices charged by service providers fell for the first time since June 2013, and fell at the fastest rate since November 2010. This provides further evidence that inflation in the US is not meeting the requirements for the Fed to raise rates.

The probability for a September Fed rate rise still sits at 30% ahead of the non-farm payrolls number release. All the recent data has indicated that it would be inopportune for the Fed to raise rates on 17 September, but there clearly is still a lot of repricing in the market that has to happen ahead of this date. This will be creating a lot of volatility in the FX markets, as the focus then turns to the likelihood of rate hikes at the October or December meeting.

In the wake of the European Central Bank (ECB) meeting last night, it appears likely that they will step up quantitative easing (QE) stimulus with most seeing December as a potential starting date. The trade-weighted index for the euro saw an immediate 0.9% drop in the wake of the ECB meeting, with further weakness in its outlook going forward as a stepped up QE program continues to be priced in.

This brings the focus to the Japanese yen. If US non-farm payrolls disappoint and the ECB is planning to step up QE, which currency is most likely to strengthen against these two pairs?

The news coming out of Japan at the moment is indicating how difficult it may be for the Bank of Japan (BoJ) to increase the scale of its Quantitative and Qualitative Easing (QQE) program. The Shinzo Abe government has just passed a new law giving all Japanese citizens a number (dubbed 'My Number'), which they will have to use for taxes and social security in 2016. This new system is meant to make it harder for people to avoid taxes and improve the government’s revenue collection in an attempt to reign in Japan’s ballooning fiscal deficit.

Concerns have also emerged over the lack of liquidity in Japan’s T-Bill market due to the BoJ’s asset purchases. Traders have stated that it is almost impossible to buy T-Bills in the market. The BoJ bought 90% of the six-month T-Bills issued in August and a similar amount of the one-year issues.

Noted BoJ hawk Takahide Kiuchi has recently stated that the unintended side-effects of the BoJ’s QQE program only stand to increase as time goes on. And his recent statements appear to be getting more consideration than they have been in the past.

The BoJ is well off hitting its 2% inflation target by next year, but there appears to be increasing reluctance for any increase to the QQE program. This state of affairs is likely to strengthen the JPY, particularly in the wake of a disappointing US non-farm payrolls number.

The USD/JPY is in a very clear downtrend at the moment, with any noticeable rallies above the 120 level merely being good entry points for further shorts.

This state of affairs is also going to continue to weigh on the Nikkei, with many companies being negatively impacted by a strengthening Japanese yen.

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