Getting Richer By Getting Poorer - Japan's FX-Bond-Stock Trilemma

Via Steven Englander of Citi,

Getting richer by getting poorer -- How far does JPY have to fall?

JPY could fall a lot further because weak JPY has been the most effective tool to create equity market wealth and spur Japanese demand. Moreover, Japanese policymakers do not have many other options. The policymakers may be technically correct in saying that policy is aimed at domestic targets, but the exchange rate happens to be the most effective lever to achieve their domestic goals.  Friday’s 1.8% drop in the Nikkei on the back of FM Aso’s comments were a warning that JPY strength would be a significant setback to the gains Japan’s asset markets have made in recent months.

The USDJPY and Japan equity market rallies have been pretty spectacular since early November and obviously pretty correlated (Figure 1). However, putting the Nikkei in perspective, even with the gains of the last three months it is a very significant underperformer. Moreover, it was underperforming even before the March 2011 tsunami/earthquake, and the recent up move has brought it barely above 2010 highs (Figure 2).

Put together these two propositions:

  1. Japanese equities have underperformed greatly over the last five years, and
  2. a weaker yen has been by far the most effective tool to generate Nikkei outperformance

and it is very reasonable to ask the question how much further JPY weakness has to go to fully unwind the underperformance of the last few years. We stress the Nikkei both because of its wealth effects and because translation effects for Japanese firms make them far more profitable and on the margin are as good as fiscal policy to encourage them to invest.

Figure 1. JPY and Nikkei


Figure 2. US S&P outperforming Nikkei


The answer is that JPY could have a lot further to fall.

Consider Figure 3 below, which plots the ratio of the Nikkei to S&P (blue line) and USDJPY (red line). If JPY is ticket for the Nikkei to regains ground lost versus other equity markets, USDJPY would have to go into three digits. For the Nikkei to regain the ground lost since early 2010, it’s relative gain since early November would have to be doubled. By implication JPY would have to weaken a lot more.

A similar picture emerges for the KOSPI-Nikkei relationship and JPYKRW (Figure 4).  While the Nikkei has gained significant ground agaisnt the KOSPI, since November, it is nowhere near where it was in 2010 and if JPYKRW is the leve4 to get the blue line back up, the red line will have ot move a long way.

Figure 3 Nikkei vs S&P and USDJPY

Figure 4. Nikkei vs KOSPI and JPYKRW


To be clear, the exchange rate is not the only possible way of pushing the Nikkei up. The BoJ could buy equities, supporting the Nikkei and injecting liquidity, but that may be viewed as too artificial even by modern central banking standards. The Japanese governments may be less ambitious than to try to fully restore ther 2010 parity between the Nikkei and other global equity markets, and hence more reluctant to weaken JPY. Japanese firms could also regain their innovative and branding edge, but there is no short-term policy tool at hand to achieve that.

If criticized at G20,  Japanese policymakers can counter that the equity market underperformance also reflects a major loss of export market share, both since 2000 and 2007, so there is some evidence that the exchange rate has been a significant contributing factor to the Nikkei’s and Japan’s relative weakness. Japan have also lost additional share since mid-2012 when political issues with China led to a loss in market share there.


The loss of market share in part reflects long-term structural issues but Japanese governments (like others) are more mindful of inurring the anger of domestic political constituencies by making tough structural reforms than of G20 counterparts by weakening the exchange rate. More importantly, if they are trying to use the exchange rate (i.e. pure export price competition) to offset these structural factors they will have to use the exchange rate aggressively to corwd in not only exports lost because of the time spend bu USDJPY below 80, but also to crowd in exports lost because of structural factors. All point to JPY weakness ahead. From a political perspective, the Nikkei-JPY relationship is too much a good thing for Japnese policymakers to give up.  

[ZH: However, for a nation looking to encourage an inflationary outlook and break the back of deflation, the nation's short-term bond markets (for now) are not playing along. In fact, 2Y JGB yields have plunged from 10bps to 3bps in the last few weeks. We assume this is as much driven by a rush into the carry trade (borrow short-dated JPY cheap, sell JPY for USD, invest USD in whatever - thanks to Abe's 'floor' under JPY removing one risk from the trade) as it is a market entirely bereft of belief that the deflation can be beaten. We have seen these kind of major dislocations between USDJPY and the rate-differentials in the past...

The last time USDJPY was at these levels, 2Y Treasury yields were 1.2% (compared to the current 25bps). It seems that would send a shockwave through US markets if short-term rates blew 100bps wider to 'confirm' USDJPY's move.

It is worth noting, however, that since the dot-com bust (heavily carry funded) the relationship between USD-JPY rate differentials and USDJPY has flipped...

And, it seems the world not only knows of this short JPY trade but is in it - as net short JPY commitments are the largest ever...

But while the short-end of the JGB curve continues to ignore inflation, it appears the long-end is very much paying attention. In the chart above, the long-end of the JGB curve (10s30s) is steepening dramatically - to record steeps, as even a small chance of hyperinflation has a large impact on longer-dated bonds. ]


Source: Citi


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