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Forex pairs in this Article » USD/JPY (Barcelona) - The HSBC strategy team have taken a look at the political situation in Japan and the effect it has on the Yen and how best to approach the upcoming election on December 16th.

Opinion polls indicate that the LDP will form a ruling coalition and be lead by Shinzo Abe, a former PM, who will inherit an economy in recession. Naturally, a great deal of focus has been placed on economic policy reform, both on the monetary and fiscal front. The team note that the prospect of turning on the taps has energised Yen bears and USDJPY has spiked higher while the glacial decline in trade weighted JPY gathered considerable pace.

They feel that the sell off is justifiable in one regard as there is a long list of prospective options on how to spice up economic policy in Japan. Higher inflation targets have been mentioned, the BoJ's mandate could be expanded to mirror the Fed's and factor in employment levels, a rapid expansion of the existing APP could take place, rates could be set to zero or even negative, the BoJ could buy bonds to fund construction projects and the BoJ and private sector could buy foreign bonds to weaken JPY as well. The team are also expecting a more dovish shift in BoJ policy over the coming year.

As such the team argue that there have been mini-rallies in USDJPY in the past, the JPY bears insist that this time is different. On the face of it they feel that the move higher appears justified. An incoming PM is proposing a radical expansion of monetary and fiscal policy and the market is buying into the idea allowing the JPY to disentangle itself from the global vagaries of risk on risk off and adopt a more insular focus.

They note that with Japan, the currency is seen as the best way to capitalise on expectations, in contrast to elsewhere. In the US, fiscal uncertainty is expressed through equities rather than the ambiguous USD. In Europe, the bond market provides the most appropriate vehicle to play the sovereign crisis, rather than the Euro.

However, the problem for JPY Bears, in the teams opinion, is that they are getting excited about a list of events that has yet to happen and may never happen. Like a child at Christmas, the team feel that we are witness the buzz of anticipation. However, the question is, will they get everything that they hope for? They feel that the same question could be levelled at Abe, who they are not sure can deliver on all of his pre-election promises.

For many of the bold steps proposed would require a significant deviation from the norm and questions surrounding legality would also crop up. Meanwhile, the merits of negative interest rates are still up for question by many economists with many fearing that they could have a distortive effect on the behaviour of banks and other economic agents.

The suggestion of raising the inflation target also comes under scrutiny too. Abe's suggestion of opening the monetary floodgates is radical and even more ambitious when viewed through a historical context. Inflation has only really moved above 2% in Japan during energy crisis'so for a proposed push to 2-3% is quite something and there are mounting questions over whether it can be achieved through the proposed means.

Aside from the questions of 'whether', questions of 'when'add to the uncertainty. Even assuming that Abe is able to get his complete wish list, the time frame for achieving and implementing them is unknown and whether they are achieved before the market looses patience is another question. The team ask, "The changing of the guard at the BoJ is not scheduled until March/April 2013. Should we really sell the JPY now on the basis of policy changes which may or may not change sometime in the middle of 2013?"

Overall, they conclude, " We have been here before. The market has become especially excited that the forecasts of JPY weakness may finally be bearing fruit. But so far we remain in the realm of promises not reality, and we believe this latest lurch in the JPY will go the way of its predecessors, namely into reverse. We retain our year-end 2012 forecast of 78 for USDJPY and stability thereafter."
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