Policy mix in Japan not good news for the yen

SPECULATION has been rife in the markets that the Bank of Japan is mulling new liquidity measures to fight the deflationary pressures that are building in the Japanese economy. And yesterday, Japanese finance minister Naoto Kan added fuel to the speculative fire, saying that the central bank can make an inflationary impact with monetary policy.

At a time when most central banks are at least thinking about withdrawing liquidity provision, further expansionary monetary policy will not do the yen any good at all.

Foreign exchange traders looking at Japan are best to trade US dollar-yen because it is the most liquid Japanese cross, and is also the most sensitive to surprises in US data. Strategists at BNP Paribas say that a major bottom is developing in the pair at the ¥90 level and while stronger forecast growth in the US will continue to push the dollar higher, they see the bigger driving forces coming from Japan, pushing down on the yen.

Firstly, any policy action by the Bank of Japan is unlikely to be yen-positive – the analysts at BNP Paribas believe that the potential extension of the lending facility will not be enough and the central bank will be forced to take more drastic action at some stage, including a move back into full quantitative easing with the increased purchases of Japanese government bonds.

Secondly, regardless of what the Bank of Japan actually decides to do, Japan is not a candidate for a strong currency. It has the lowest interest rates in the G10, making it a prime funding currency for carry traders. It has also run a budget deficit for years and its fiscal situation is in a parlous state – the gross government debt-to-GDP ratio has already breached 200 per cent – and its sovereign debt rating was downgraded by ratings agencies earlier this year.

Thirdly, Japanese investors are continuing to search out higher-yielding overseas assets as interest rates in their own country stay close to zero. Savings ratios have fallen from their previously high lows and those who are still putting money aside are sending it abroad. This should add to weakness in the yen, especially since interest rate differentials are unlikely to favour the Japanese currency.

During the financial crisis, the yen had managed to strengthen against the dollar thanks to its positive correlation with risk aversion. Although sovereign debt troubles in recent weeks have kept the yen stronger than it might otherwise have been, expansionary monetary policy in Japan, combined with the global recovery gathering steam, should keep the pressure on the yen.

Currency traders should still be looking to take out long positions in dollar-yen, particularly if we are at a major bottom, and the near-term target should be around ¥93.