JPY strength may be overdone; NKY resilience justified
The USD/JPY has tested low 110s five times, including today, over the past two weeks. The pair has not resumed its rally as quickly as we had expected, but we believe the medium-term upward trend has not ended. Two questions have come up recently: why has Japanese equity been relatively resilient despite theUSD/JPY weakness, and, why has the JPY been so strong this year. To answer these, we first leverage on our earlier factor analysis, where we employed the principal component analysis (PCA) to extract factors that summarize key global drivers in order to derive estimated change in each market. The results are shown in Chart 1. We have the following observations:
1)The Japanese yen has risen both in the effective term and against the USD, despite changes in global factors year-to-date not implying a stronger JPY rate.
2)The USD/JPY is estimated to be higher, by roughly 5%, as compared with the actual level. This observation seems roughly consistent with a graphical inspection of the widening gap between the USD/JPY and the US-Japan real yield spread (Chart 2).
3) Japanese equity has significantly lagged global factors in the yen term, but the magnitude of underperformance dramatically diminishes in the USD term. We could argue that relative resilience of Japanese equity has been supported by fundamentals and a potential correction of the JPY strength is likely to lift Japanese equity in the yen term.
Chart 1: Actual change 2017 YTD vs. estimated change
Chart 2: USD/JPY lagging real yield spread
Uncertainty alone may not explain the JPY strength
What could have driven this potentially outstanding JPY strength? One potential driver is a set of upcoming global risk events that may have not been captured by the model factors but could have influenced the JPY’s demand/supply and risk assessment. April brings a series of risk events, including Kim Il-sung’s birthday (15 April) amid elevated geopolitical risk in the region, the French presidential election (23 April), and the US Treasury’s semiannual currency report and the funding deadline (late-April). Locally, Japan and the US are expected to start discussion on economic cooperation when Vice President Pence visits Japan on 18-19 April.
However, the USD/JPY and cross yen pairs have underperformed markets that seem at least as equally sensitive to these events (Chart 3-Chart 5). We next look at potential flow factors that could have contributed to JPY’s outperformance.
Chart 3: USD/JPY vs Dec ’17 FF futures
Chart 4: EUR/JPY vs OAT-bund spread
Chart 5: JPY/KRW vs KOSPI
One source of the USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real export (Chart 6). There is a possibility that the final months of the fiscal year generated additional USD selling.
As fiscal 2017 starts, we think corporate hedging should be more orderly unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16 (last year), while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view(Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4, which is lower than the spot rate. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year.
Chart 6: Japan back to trade surplus
Chart 7: Cumulative USD/JPY % change in different time zone
Japanese real money
We have also seen a notable slowdown in foreign securities purchase by Japanese investors since the US election in November (Chart 8). The slowdown probably reflects position unwinding among bank accounts and a “wait and see” stance among Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year. Banks could continue to unwind Treasuries, but it would involve little FX impacts as they usually fund these investments in the USD.
There is a strong seasonality of increased foreign bond purchase by insurance accounts during the early part of Japanese fiscal year. This year, we observe: (1) rising yields in the JGB’s superlong sector but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and a lower USD/JPY (Chart 9). It is unlikely that they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds, but we believe the USD demand will increase in the next few months.
Together with potential moderation of corporate hedging, we believe the USD/JPY will be more resilient during Tokyo trading hours (Chart 7).
Chart 8: Cumulative foreign securities purchase by Japanese real money (tn JPY)
Chart 9: Bond yields for Japanese investors
Reaction of foreign money to the Republican sweep has been different between Japanese equity and Japanese yen (Chart 10). Both the CFTC data and our own flow analysis suggest foreign hedge funds sold JPY after the US election to a crowded level by end-2016($/¥’s rally may be finally close to exhaustion – for now… 12 December 2016). Since the beginning of this year, our study shows relentless unwinding of JPY shorts. In the CFTC data, unwinding is more moderate but the net short position is now 40% less than its December peak. Residual JPY shorts observed in CFTC statistics may imply heaviness of the USD/JPY for the time being as we go through risk events in April, but positioning should now be much cleaner.
Japanese equity, on the other hand, saw less intense flows from foreigners after the US election. This could have contributed to a diminished beta of Japanese equity to the USD/JPY, both on its way up and way down over the past six months. Our discussions with foreign investors indicate their macro-level interest in Japanese equity is unlikely to return until the USD/JPY clearly resumes its uptrend, and for now, their focus is on domestic stories such as labor shortage.
Chart 10: JPY and Japan equity positioning by foreigners
Chart 11: JPY relative positioning, past 12 months (Liquid Cross Border Flows)
Our USD/JPY view
While our bullish stance on the USD/JPY since late-January has not materialized yet, we believe the medium-term upward trend in the USD/JPY has not ended. The JPY strength year-to-date looks overdone to us, and our team sees a high probability that tax reform will be implemented this year and the US-Japan policy divergence will deepen, widening US-Japan interest rate spreads.
The pair could go through a volatile April, a month full of risk events, but the extent of JPY strength should limit further upside. If the USD/JPY breaks 110, the point at which our standing recommendation stops out, an extension to 108s is a technical possibility. However, in our view, unless such a dip is accompanied by a significant deterioration in economic fundamentals, its duration should be short.
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