Goldman Joins BofA In Calling For Sub-79 USDJPY Over Next 6 Months Despite Intervention
Central banks (and specifically their credibility) just can't get any love these days. Why should they: the Swiss National Bank spent a boatload, blew up its balance sheet, pissed off trade unions, and achieved nothing at all. And if Japan itself is any indication, the BOJ spent $300 billion a few years ago, and the JPY still hit all time highs yesterday. So unless someone believes that the BOJ can afford to spend about double that number to actually achieve results (and they can't) every uptick in the JPY should be shorted (and that ignores that stench that Schumer is about to raise any minute calling for a boycott of every Prius and Sony TV in the US for ever and ever as long as the BOJ continues to manipulate). Even Goldman's Thomas Stolper, who tends to be somewhat more polite than Zero Hedge, has come out with a 6 month target in the USDJPY below 79 due to the "impact of US QE, persistent trade surpluses and the attraction of testing the authorities’ resolve to intervene again." We would certainly agree on this one.
From Goldman's Thomas Stolper
Japan Goes for the "Big Splash"
Japan’s current “big-splash” intervention approach is likely to succeed, mainly because fundamentally $/JPY is already very overvalued and likely close to the bottom. That said, over the next 6 months the impact of US QE, persistent trade surpluses and the attraction of testing the authorities’ resolve to intervene again could result in marginal new lows below 79. During that period more interventions are likely.
“Big Splash” or “Steady Drip”? In terms of how FX interventions work, the academic literature differentiates between two principal channels. The first is simply the signalling effect, which aims to shift one-sided perceptions through the creation of two-way risk. Interventions using this channel are typically very concentrated, often when market liquidity is low, are highly visible and immediately confirmed by the authorities. Volatility rises. The total volumes are relatively low in the context of overall market liquidity but they appear very large because they are highly concentrated. Today's intervention in $/JPY was one of these “big splash” interventions.
The second channel is based more on what you would call a variant of QE. The authorities buy foreign assets at a more or less well-defined FX intervention level. This increases the money supply and effectively eases monetary policy, putting downward pressure on the currency. This type of intervention tends to reduce volatility. It is often disguised by the authorities but it involves many small (often daily) transactions, and ultimately large cumulative volumes. The recent Swiss interventions - and the Japanese interventions in 2003/04 - were largely of this “steady drip” type.
Policy Constraints. “Big Splash” interventions rarely create tensions with the governments of other countries. The primary aim is to change biased perceptions or to slow disruptive price action. Indeed, “big splash” interventions are almost always triggered when a) markets have moved very quickly, b) there is evidence of sizable and growing speculative interest, c) technical factors, often option-related, could lead to further acceleration of an already fast move, or any combination. Given that these conditions were more or less met, as described by Fiona Lake in our Global Markets Daily today, the wrath of fellow G7 members is unlikely to fall on Japan’s Authorities. In particular there has been growing evidence of a build-up of speculative short $/JPY positioning in recent days. Even a second “big splash” intervention in the next few days, pushing $/JPY higher again (for example from 85 to 87), would still be consistent with the “big splash” approach.
On the other hand, Japan would likely come under pressure if other governments get the impression that Japan’s interventions are gradually morphing into the “steady drip” type. Bear in mind that the “stead drip” is also the tool used to keep a pegged currency pegged. In other words a “steady drip” approach by the Japanese would immediately cause concerns that Japan is attempting to stand in the way of global rebalancing. Moreover, there would be an inconsistency with the policy pressure that other countries in Asia are experiencing, in particular China, but increasingly also Korea. On that basis, the Japanese Authorities are fairly unlikely to decide to intervene repeatedly at the 83 level. Joint interventions with other G7 countries are highly unlikely for the same political reasons.
Game Theory. Assuming the “big splash” template, it is very difficult - if not impossible - to second-guess the authorities, who have an information advantage. As the FX market is quite transparent, the authorities will be able to gain a reasonably good sense of what the average market player thinks the authorities will do next. As a result, it is easy to surprise the market. For example, if people assume the next intervention will start at slightly lower levels than the previous one, chances are the authorities will step in earlier – and vice versa. The fact that the MoF intervened after Kan’s DPJ election success is a very good example, because markets clearly thought the likelihood of intervention had been reduced. This quickly becomes an unfathomable game of second-guessing, which ultimately paralyses all speculative activity – a success for the authorities.
Fundamental flows. Where “big splash” interventions can fail is in the face of fundamental appreciation pressure. In that case, the markets would simply take advantage of better levels and continue to buy the Yen as they would have done anyway. “Big splash” can then quickly become “steady drip”, and often results in potential over-accumulation of reserves and considerable money supply management challenges, in addition to the external political pressures mentioned above.
Looking at the current circumstances, it is not easy to decide whether fundamental appreciation pressures have all disappeared.
The excitement about the DPJ election outcome and related potential for JPY strength are more part of the second-guessing game than a true fundamental factor, as mentioned above. Flows related to the fiscal half-year may have played a role but these will be over within days, suggesting that the chances of successful intervention have increased.
On the other hand, there are still some factors which call for more Yen strength. If the Fed does engage in QE, as we assume, then the rate differential may push $/JPY even lower and in fact quite close to record lows when looking at past relationships with rates . There is also the persistently large Japanese trade surplus, there is growing anecdotal micro evidence that Yen valuation is starting to hurt Japanese exports. On a trade weighted basis the JPY is now 21% overvalued and $/JPY GSDEER points to a fair value in the 105 area, as recently highlighted by Robin Brooks. Slowing exports are consistent with further monetary easing by the BOJ, which in turn would supports the intervention stance.
What will happen? Given our view on US rates markets and still decent support from the trade balance, the near-term risks are still skewed towards marginal additional $/JPY strength. A test of historic record lows below 79 appears possible, in particular if option related activity has the potential to accelerate a down move, as we have seen in the past. But in reality we are likely quite close to the bottom of $/JPY. Fundamental support for further Yen appreciation is fading as valuation starts to hurt trade flows, and rates differentials approach the lower bound. In this environment, the chances of “big splash” interventions eventually succeeding are quite high.
Our forecasts remain 85 and 83 in 3 and 6 months, although we think a temporary move to marginal new lows is possible. Over a 12-month horizon, we maintain our “GSDEER reminder” and forecast $/JPY at 90.