Morning Commentary: Yen 2021: Real Gains

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

Yen 2021: Real Gains Share this story: Andrew Kositkun Foreign Exchange Head Trader

The Japanese yen should finish 2020 in the middle of the G10 pack, as it currently sits roughly 4% stronger against the U.S. dollar. But it was really a year of two halves. The first half came during the pre-COVID-19 period that was characterized by large and persistent onshore yen sales. This gave way to the post-COVID-19 half that saw a collapse in global nominal yields that decelerated Japan’s unhedged investment outflows and turned USDJPY’s trend weakness into trend strength. In 2021, the outlook is for a continuation of trend strength, as real yields and inflation spread remain in the yen’s favor. Japan is expected to benefit from Asia’s low COVID-19 infection rates, but its growth within the G10 will be differentiated by the lack of inflation pressures due to a persistent negative output gap and the disinflationary impact of fiscal subsidies. The yen’s correlation to some market measures has fallen, but the relationship with real yield spreads and relative U.S.–Japan inflation expectations remain. Because of this, the recent expansion of U.S.–Japan CPI spreads supports the narrative for continued yen strength. Further, the increasingly crowded low-yielding currency club has reduced the yen’s role as a funding currency, and the yen’s cheap valuation has deterred yen shorts. As such, the yen’s correlation to short-term swings in risk has been reduced, leaving fundamental factors such as Japan’s positive real yields and solid current account surplus, both appreciating factors, to be the key influences on the yen. Moreover, the mix of higher Japanese real yields and lower nominal global yields suggests a sustained drop in the pace of Japan’s outbound investment flow that will diminish a long-standing source of yen weakness. With the yen set to appreciate further, questions around intervention will undoubtedly arise, especially as USDJPY gets closer to 100. For now, intervention appears to be an unlikely event for the following reasons. First, the correlation between a drop in domestic equities and declines in USDJPY has collapsed. If yen strength doesn’t lead to a drop in domestic equities and the associated drop in sentiment, then intervention is less likely. Second, intervention falls under the jurisdiction of the Ministry of Finance. This means that geopolitics and the U.S.–Japan relationship will play a role, and it isn’t insignificant that Japan has already met two of the U.S. Treasury’s three criteria to be labeled a currency manipulator. Back in the early 2000s, Prime Minister Junichiro Koizumi developed a close relationship with President George Bush, and Japan was able to intervene heavily even with USDJPY as high as 110–115. By contrast, turnover of prime ministers during the next six years prevented the development U.S.–Japan ties. As a result, intervention didn’t come until USDJPY fell to 83. Only time will tell how the Biden–Suga relationship will develop. HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: U.S. initial jobless claims came in at 712,000, beating expectations for 775,000 claims. Continuing claims also beat expectations, coming in at 5.5 million against expectations for 5.8 million continuing claims. On the virus front, the U.S. had its deadliest day, with fatalities topping 2,700 and hospitalizations passing 100,000 for the first time. However, vaccine distribution optimism and perceived progress on U.S. fiscal stimulus have boosted risk sentiment and pushed the 2-year/10-year yield curve to its steepest level since the beginning of 2018. For now, markets have not moved the 10-year yield above 1%, but should this happen, it would likely trigger Fed action. On the stimulus front, Democratic leaders Nancy Pelosi and Chuck Schumer threw their support behind the $908 billion bipartisan compromise fiscal stimulus proposal as the foundation for new talks. The good news is that a stimulus package before year-end looks increasingly likely; however, the bad news is that it will be smaller than expected. OPEC+ is discussing a plan that will taper output cuts through January and then raise production by 500,000 barrels a day from February to May. This proposal represents a shift from the market’s expectation for a three-month extension to production cuts. U.S.–China tensions are back in the news after the House backed a proposal that could lead to Chinese firms being delisted if regulators are not allowed to review their audits. President Trump is expected to sign the bill into law. The U.S. has also restricted travel visas for members of the Chinese Communist Party and banned cotton imports from a military-linked Xinjiang firm. News reports suggest that the Bank of Japan is likely to extend its emergency measures at its next meeting on Dec. 17–18. With infection rates rising, it makes sense to extend emergency measures to coincide with when the next fiscal package is due. Brexit noise continues, with reports of the French taking a tougher stance on fisheries as talks go down to the wire. The EU summit is on Dec. 10, and hopes remain for a deal to be struck by then. While markets are still expecting a deal, demand for downside protection has picked up. Final PMI data out of the U.S., U.K. and the eurozone all improved from their preliminary readings. Chinese PMI data also came in strong, with foreign-investor demand for Chinese fixed-income assets also remaining strong in November. The continued recovery in China has prompted some initial talks of when the central bank will change its policy stance. Despite positive economic performance, any change in policy stance will come very gradually. To quote a former central bank official, “China is far from meeting the conditions for tightening monetary policy.”

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