Yen rally offers opportunity to increase USD risk

Homin Lee, Asia Regional economist at Lombard Odier, comments on how yen strength is nearing its end.

We believe the recent strength in the yen is nearing its end. While the currency strengthened even further on the news of inaction at the Bank of Japan’s (BOJ) policy meeting last week, macro or policy tailwinds for the currency will start to fade in the coming months. We have three reasons for this view.

  1. The BOJ will likely ease again in July to bolster its policy credibility. The BOJ’s 2% inflation target has been severely undermined by the recent series of restraint, communication errors, and rampant rumours about tacit (or covert) currency market coordination with the US. The negative cumulative impact of these developments is now very clear. Effectively all of Japan’s market or survey-based measures of medium- to long-term inflation expectations are now lower than where they were at the start of Kuroda’s term as BOJ Governor. We believe, therefore, that the BOJ’s bias to limit downside risks will be substantial for the coming policy meetings. July provides an attractive window in terms of comprehensive guidance (forecast updates) and the political calendar (Brexit and Japan’s upper house election will have been confirmed).
  1. Further strength in the yen will actually increase the scope for the BOJ’s easing or the Japanese government’s currency market intervention. A policy package that lifts USDJPY to 150 is fundamentally provocative to Japan’s trading partners (especially the US), but the one that is designed to push back against any excessive rally in the yen is more acceptable to G7/G20 countries. Japan’s Finance Minister Aso has already defined a de facto threshold for direct market intervention as a two day movement in USDJPY in excess of 5 yen. Furthermore, the US government’s new currency policy allows limited market intervention that does not exceed 2% of GDP over a 12 month period. This option will cap the yen’s rally in the intervening weeks between now and July’s BOJ meeting.
  1. Investors’ bullish positions on the yen have reached an excessive level, thus increasing the risk of rapid reversal on data surprises or policy innovation. Speculative positions on the yen remain in historic net long territory, and the market reaction to the BOJ inaction hints that more short positions are being unwound despite the broad consensus expectation that did not see any change. This raises the sensitivity of the currency market to the likely bounce-back in the US data and Japan’s possible innovation in July. We are aware of the argument that such a situation can persist for quite a while but that would be the question of the BOJ’s policy framework, not natural market tendencies.

We will, therefore, consider any significant rally in the yen as a tactical opportunity to increase the US dollar risk in our yen portfolios. Event risks on the horizon are indeed worrisome, but the balance of risk and reward has probably shifted decisively in favour of the weaker yen.

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