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Forex pairs in this Article » USD/JPY (New York) - The USD/JPY has been trading in a rather undefined path as of late, however coupled with the overall performance of the Japanese Nikkei, a correlation starts to emerge that could ultimately shed new light on seemingly Neolithic debates regarding BoJ stimulus.

Indeed, there has been a long held belief about a positive relationship between the USD/JPY foreign exchange rate and the Nikkei, with the fallout of the BoJ earlier this year providing the impetus for both constructs to rise bullishly, consequently diving in parallel fashion. Ultimately however, a closer introspection of the two needs to be examined as correlation does not imply causation.

According to FX Strategist Greg Gibbs at RBS, “While there is certainly a correlation between the two, it does not fundamentally make sense for a weaker Nikkei to strengthen the JPY. Indeed, the Nikkei puts pressure on the BoJ to increase its monetary easing, though it suggests that Japanese investors are sensing the economy is slipping into its old deflationary cycle and it is best to hold savings in zero yielding bank deposits.”

As such, if the BoJ were to witness the prolonging of the recent trend, it would plausibly lead to an augmentation in its QE policy, sooner rather than later. “Ironically, over a greater time interval, the weaker Nikkei is in fact negative for JPY and a sustained fall in both the Nikkei and USD/JPY is unlikely as it will soon generate more aggressive BoJ policy easing that will in turn weaken the JPY" Gibbs adds.

In the aforementioned scenario, the Nikkei increases too rapidly, with its vector achieving ‘escape velocity. In turn, this could potentially be negative for the USD/JPY, because it implies that the BoJ’s QE policy is working more in line with boosting domestic assets rather than the acute weakening of the JPY. Indeed, “This supports the notion that prospects for inflationary expectations would ultimately rise,” Gibbs notes – as the BoJ QE policy is sufficient and in this instance would not need further enhancement to achieve its 2.0% inflationary goal in a period of two years.

Conversely, an unsustainable thrust of the USD/JPY could place the Nikkei in a negative feedback loop given that it fosters inflation that is primarily for imported goods, which could be viewed as a taxation operative – particularly for domestic-based companies – that may provide an impetus for mounting Japanese bond yields. Moreover, one needn’t look further than inflationary expectations and higher risk premium on JGBs that in turn hurts the real estate sector and bank balance sheets.

That being said, a rapid – and perhaps of greater weight – unsustainable thrust in the Nikkei could potentially debilitate the USD/JPY. By extension, a rapid rise in the USD/JPY could also cripple the Nikkei - when scenario either occurs, the correlation between the two will appear very high, hence the distortion in perception.

Amidst this corollary, Gibbs suspects that as things stand, the sharp slide in the Nikkei will soon underpin the USD/JPY. It would serve as a surprise to see an upturn in the USD/JPY then drag up the Nikkei. The BoJ and the Japanese government are not going to sit by and observe a cataclysmic fall in the Nikkei in conjunction with the USD/JPY. Both are linear indications that immediate and diligent action would need undertaking, most likely in the form of policy easing. If the past has been any indication, there should be little doubt that both would refrain from doing so in aggressive and dramatic fashion.
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