Japanese Yen outlook : RBC

RBC Capital Markets notes:

1 - 3 Month Outlook - Grinding JPY weakness

USD/JPY finally broke higher in late-May, with the rise through 124 talking JPY to its weakest since 2002. It is hard to tie the move to any particular domestic news flow. 

The BoJ left policy unchanged at the late-April meeting and there is little realistic prospect of more easing now until the next forecast update in October. Domestic data continue to point to little in the way of positive economic dividends from a weaker JPY. 

Although headline Q1 GDP was better than expected (0.6% q/q; consensus 0.4%), the detail was poor and the net trade contribution was negative (-0.2% point contribution), despite a huge fall in JPY in the previous six months. Moreover, as the consumption tax hike dropped out of the annual inflation rate, CPI inflation fell back to just 0.3% y/y (ex-fresh food) in April and there is still no evidence of second round effects from previous JPY weakness or any evidence of rising inflation expectations amongst consumers. 

Despite the lack of evidence that a falling JPY is achieving much, and the absence of a domestic policy driver, we think USD/JPY keeps grinding higher in the short-term on the basis of persistent JPY selling flow. 

The main source of this flow is the public sector (GPIF and others) and the main destination is foreign equities. In recent months, much of this JPY selling was absorbed by an unwind of leveraged JPY shorts , but with positioning now much closer to neutral, the risk of ongoing capital outflows driving JPY down is much higher.

6 - 12 Month Outlook - Another leg down

We think two sectors were responsible for the first two legs of JPY selling - the overseas sector fuelled the move from 80 to 100; the domestic public sector drove the move from 100 to 120. 

The sector we expect to drive the third leg of JPY selling has so far had limited involvement and appears to be largely indifferent to domestic policy - the Japanese private sector, specifically, bond investors. Unlike the equity flow data , the raw bond flows tell us little about the supply/demand balance for the currency as much fixed income investment is currency hedged. 

Indeed for fixed income investors, shifts in hedging behavior have the potential to generate much bigger FX flows than the cross-border asset movements themselves as they affect the entire stock of existing investment, not just the current flow. As US short rates rise, so does the cost of hedging and we still expect an unintended consequence of higher US rates to be another big leg down in JPY (target: 132)