If the Bank of Japan (BOJ) wants to weaken the yen, it better stop what it’s doing.
Its ultra-loose monetary policy easing program, known as “Quantitative and Qualitative Monetary Easing with a Negative Interest Rate” is actually contributing the yen’s continued rise.
That’s the view offered by Binky Chadha, Parag Thatte and Rajat Dua, members of Deutsche Bank’s asset allocation strategy team, who believe that the BOJ’s stance is creating negative fundamental impacts on growth and risk appetite in Japan.
In other words, it’s exacerbating the problem, not helping it.
“In striking contrast to traditional wisdom that monetary easing should see the exchange rate depreciate, the BOJ’s move to negative rates in January saw Japanese bond yields fall but the yen appreciate,” the trio wrote in a research note released earlier this week.
“In fact the higher yen has been stunningly (93%) correlated with falling JGB [Japanese government bond] yields for some time now, since early 2015.
“Is the rise in the yen explained by rate differentials or bigger declines in US and European yields? No. These have continued to move in favor of a lower yen. This leaves little doubt it has been BOJ-induced declines in Japanese yields that drove the yen higher.”
The chart below, supplied by Deutsche, shows the relationship between the USD/JPY and benchmark 10-year JGB yields. It’s certainly a close relationship, and a highly unusual one at that.
Chadha, Thatte and Dua believe that the anomaly has been driven by the BOJ itself. Instead of bolstering confidence, the actions undertaken by the bank are having the opposite effect.
“Given that Japan and more recently also Europe have trade surpluses and these flows tend to be sticky, they create natural pressure for the currencies to appreciate. For these currencies to remain unchanged or depreciate there need to be equal or larger offsetting capital outflows,” they say.
“If monetary policy easing has a negative impact on prospects for growth and diminishes local risk appetite, it will reduce capital outflows and result in upward pressure on the currency.”
They point to factors such as lower returns on household savings, capital flows from stocks to bonds, depressed bank earnings and plummeting bond yields signalling poor prospects for inflation and growth as factors that have contributed to decline in confidence levels.
In unison with the BOJ’s actions contributing to the recent move, Chadha, Thatte and Dua believe that yen is also correcting having fallen way beyond fundamental levels in the early stages of when “Abenomics” was introduced.
“The yen did decline beginning in the fall of 2012 on expectations of monetary easing in the run up to the launch of Abenomics. But this took place in the context of a “three-arrow” approach which boosted risk appetite and encouraged capital outflows,” they wrote.
“The depreciation of the yen went far beyond changes in rate differentials, both prevailing and prospective.”
And Deutsche think that there’s a lot more of this correction to go, putting it at odds with other forecasters who believe the yen will begin to weaken should markets successfully navigate a plethora of risk events ahead.
“Despite the mounting evidence the developed market central banks continue to have an aggressive easing or accommodative bias. We expect they will continue down this path for at least another round of easing, while the evidence grows to the contrary,” they note.
“In the meantime, with fair value in the mid 80s, we recommend being long the yen and underweight Japanese equities.”
When Chadha, Thatte and Dua say “mid 80s”, they’re referring to USD/JPY, something that is currently trading at 106.0.
That’s 20 big figures away, with a whole lot of financial heartbreak for both investors and the BOJ should their theory be proven correct.
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