Fundamental Update: What next for the yen

 
on November 15 2012 10:37 AM

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The yen has been a big mover this week, dropping more than 2% on a broad-based basis. The decline has been fuelled by political news: the Prime Minister of Japan will dissolve the parliament’s Lower House on Friday and elections are scheduled to be held on December 16th.

The Lower House is the most powerful law making body in Japan and has the power of veto on the Upper House. Thus, on December 17th Japan will have a new government.

Context: 

It is the second election in just three years for Japan and it takes place at a crucial time in the country’s economic history. Its public debt level is currently more than 200% of GDP and the economy is shrinking. Debt levels need to be brought down and tough decisions need to be taken on how to bring the public finances onto a more secure footing.

The government is expected to lose this election, with the opposition Liberal Democratic Party winning power for the 17th time in 18 elections since 1960…

Why this election is significant:

The economic outlook is dismal – GDP fell at a 3.5% annualised rate in the third quarter, one of the worst contractions in the West. Added to that initial growth signals for Q4 suggests that Japan is at risk of sliding into a recession at the end of this year. The economy remains mired in deflation – prices are falling at a 1% annualised rate according to the October CGPI data, which is well below the 1% inflation target set by the BOJ.

The economy is likely to be the focus of the election. This could have big ramifications for the yen after opposition leader, former PM Shinzo Abe, drew the battle lines in a speech this morning. He said:

  • He wants the benchmark interest rate cut to zero or lower
  • He is calling for unlimited BOJ easing until deflation is overcome
  • He wants to increase public investment, including defence and coast guard spending.
  • He will take a more aggressive stance over the territorial dispute with China

There are two things that yen traders need to pick up on:

1, If Abe wins the next election as expected then he is likely to reduce the BOJ’s independence and force the Bank to make more asset purchases and reduce interest rates. Lower yields may weigh on the yen in the medium-term.

2, Geopolitical tensions could heat up if Abe does win and decides to take a tougher line With China, which could also erode the status of the yen as a safe haven.

The market impact:

The yen had a sharp reaction to Abe’s comments. USDJPY has broken above a key resistance level - the top of the weekly Ichimoku cloud at 80.65. It has extended gains throughout the morning of the London session and rose to its highest level in 6-months above 81.00.

USDJPY: weekly Ichimoku cloud

Source: Forex.com

Treasuries could keep a lid on USDJPY gains

The question now is if this is the start of a new paradigm for USDJPY and have we just embarked on an uptrend for this cross? The fundamental and political backdrop is supportive of a weaker yen, however, USDJPY also moves closely with the US 10-year –Japan 10-year yield spread. As you can see in the chart below, USDJPY has moved sharply higher, we shall have to see if the US-Japan yield spread widens with it.

There are some domestic factors in the US that could keep Treasury yields depressed – the fiscal cliff is one of them. If we don’t start to see an agreement between Democrats and Republicans to deal with the tax and spending situation then we may see safe haven flows into US Treasuries. This may thwart USDJPY’s gains going forward, and is the biggest risk for this cross in the medium-term. 

USDJPY and US-Japan 10-year yield spread

Source: Bloomberg and Forex.com

Thus, for us to be convinced that we are in a new paradigm and this is not just a false break higher in USDJPY we will be looking for a weekly close above 81.80 – the high from April.

We will be watching out for any other commentary from the Japanese political parties as the market is very sensitive to their rhetoric as we lead up to the election. We believe that USDJPY will continue to trend with a bullish bias until the elections in a month’s time and any periods of weakness will be bought.

EURJPY: approaching key resistance

This cross has also been a big mover today. It is fast approaching its high from last month at 104.80. This is a key resistance level as it is the base of the weekly Ichimoku cloud. If we get a daily or weekly close above this level it would be the end of the technical downtrend and a very bullish development for this cross. Key resistance lies at 107.50- the top of the weekly cloud.

EURJPY: weekly Ichimoku cloud chart.

Source: Forex.com

Key dates for USDJPY in the near term:

19/11: machine tool orders in Japan

20/11: BOJ meeting concludes

22/11: BOJ releases monthly report

20/11: Fed governor Bernanke speaking

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957  | e: kbrooks@forex.com| w: www.forex.com/uk

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