Japanese investors have long been supporters of the European Economic and Monetary Union (EMU) deflation trade and by all accounts are now holding excessive positions in the EMU’s semi-core bond markets. For example, Japan now holds 12% of all French sovereign bonds. It isn’t only political risks which pose a risk to these investors; the EMU is also developing inflationary pressure within its core economies while at the same time, periphery economies continue to battle deflation which sees local funding costs rising at a quicker pace than local inflation rates.
Bond Market Volatility To Challenge Japanese Investors
In the run-up to the March 15th Dutch elections and the French Presidential elections in April and May, Japan’s real money investors could find it increasingly challenging to maintain exposure. Returns are likely to be weakened by recent bond market volatility, increasing the potential desire for the liquidation of positions. For example, Japanese exposure to US bonds was near record highs when US bond yields exploded higher in Autumn last year.
As a large percentage of these positions were FX hedged, the stronger USD didn’t compensate for capital losses. The high EUR FX hedge ratio for Japanese real money, which was over 80% in 3Q 2016, suggests that there might not be a substantial direct EUR weakening effect in the event of Japanese liquidation. The threat to EUR will be more indirect this time, coming via rising EMU bond spreads and their subsequent impact on financial and economic stability in the EMU.
Short-Term Rate Differential Widening To Weigh on EUR
EUR is likely to trade lower across the board as short-term widening interest rate differentials further weaken the currency. Italian banks have begun reducing their BTP (Treasury bonds) exposures somewhat, although, relative to historical levels their holdings remain fairly high. Up to this point, the ECB’s QE program has helped stabilise inner EMU bond spreads. In this context, deflationary pressures afford the ECB scope to run further QE if necessary and can be viewed therefore as a stabilising factor.
However, as signs of EMU reflation become increasingly apparent, the ECB have had reduced scope to manoeuvre. The timing of EMU bond-spread widening, which began a week after the ECB announced they would be reducing the scale of their asset purchases is, therefore, no surprise.
Downside EURJPY To Keep USDJPY Capped Near Term
Downside pressures on EURJPY should stop USDJPY from breaking higher in the near term, however, with the Fed on course to raising rates further this year, interest rate differentials will widen further and USDJPY should be comfortably back above the 116 low and should rise toward 120.
USDJPY is likely to need a little longer to build a base to break higher than these levels. Alongside a Fed rate rise, which will condition nominal rates and yield spreads, real rate and yield differentials will also be important indicators. Importantly, it will likely not be the “strong USD” story that drives USDJPY higher but a case of lower JPY real yields pushing spreads and thus taking JPY down.
Global Reflation Won’t Fuel BOJ Tightening
Global reflation has been the key theme of 2017 so far. While the BOJ is no longer considering further cuts to front-end rates, it has no intention of prematurely tightening conditions either. Consequently, it will be Japanese inflation expectations and actual inflation itself, that weighs on JPY real rates.
Lower real rates in Japan will create room for higher local asset valuations and a lower JPY. This will likely come with a tempered steepening of the Japanese government bond (JGB) curve, improving the outlook for Japanese financials. The private sector, which maintains large asset positions both domestically and abroad, could experience a surge in risk appetite, fuelling a shift into higher-yielding market sectors.
Of course, Japan’s own low yielding environment offers limited opportunities for high yield returns, and so the yield pick-up story for Japan is more about converting domestically held assets into foreign-currency-denominated assets. As such, expectations for a significant USDJPY rally over this year appear well placed, and buying opportunities should be on the priority list for traders.
For now, the price is sitting above the 38.2% retracement of the rise from last year’s lows to this year’s highs, having found support at the retest of the broken May 2016 high (111.53). Above here focus remains on the upside with the next key resistance level at 115.91 ( the December 2014 low) and the bearish trend line from 2015 highs.