USD/JPY 2006 Q4 Outlook
The second half of 2006 has brought about major changes in Japan. For the first half of the year, Japan's currency fluctuated aimlessly against its G7 counterparts with contracting ranges signaling that we could see a major move on the horizon.
USD/JPY Outlook
The second half of 2006 has brought about major changes in Japan. For the first half of the year, Japan's currency fluctuated aimlessly against its G7 counterparts with contracting ranges signaling that we could see a major move on the horizon. In the second half, a major move did occur as the Japanese yen fell to a year to date low against the US dollar and a record low against the Euro. The combination of above $70 oil prices throughout July and August, disappointing economic data and the return of the short yen carry trade has been too much for yen bulls to handle and the price action shows it. In September, carry trades returned with a vengeance to drive the yen lower, but fears of escalating tensions in North Korea was what took USD/JPY to fresh highs. At the same time, we saw the leadership in Japan change with Shinzo Abe replacing Junichiro Koizumi as Prime Minister of Japan. In the early weeks of Abe's term, we have seen initiatives that may prove to be beneficial for the Japanese economy over the longer term. Thanks to the weak value of the Japanese Yen, the outlook for the economy in the fourth quarter is already beginning to improve, leaving the door open for an interest rate hike by the central bank before the end of the year.
Weak Yen Brings to Big Benefits
As an export dependent nation, Japan benefits significantly from a weak currency. The most obvious benefit is the fact that the weaker Yen makes Japanese goods more attractive to foreign nations, but the less obvious benefit is the added revenue that a weak yen could bring for the foreign exchanging hedging operations of Japanese corporations Given that many Japanese corporations do a great deal of business abroad, it is important for them to protect their exports and foreign earnings from a rapid appreciation in the Japanese Yen. When the yen depreciates, these hedging operations can become additional revenue. Nintendo Company is a perfect example. They were the latest major conglomerate to raise their profit estimates for the second half thanks to strong sales of their new portable DS player as well as foreign exchange gains. Some Japanese corporations have simply absorbed those gains, while others have used them to drive more sales. Matsushita Electric for example has been able to reduce their prices significantly while their competitors have not by offering special customer discounts. Japanese car maker Toyota also offered major incentives in September, which has been rewarded with a record increase in US automobile sales that month. In fact, according to a recent study by Harbour-Felax Group, the USD/JPY exchange rate has increased Toyota's advantage over US automakers by $1,054 per vehicle. This strong growth in corporate profitability is beginning to help turn the economy around. The fourth quarter Tankan report indicates that businesses remain very optimistic. The Eco Watchers "man on the street index" also jumped into expansionary territory last month after having fallen into contractionary territory in the month of July. The Cabinet's consumer confidence index did not see a similar rise, but in many instances, the Eco Watchers survey has proven to be a more reliable indicator than the Cabinet's survey. August data indicated that July was a tough month for Japan on both a corporate and consumer level but the data that we have been seeing for the month of August and September is certainly showing improvements. The combination of a 26 percent drop in oil prices in the third quarter and the slide in the Japanese Yen should help turn the economy around in the fourth quarter.
Don't Expect EUR/JPY Intervention
This is the main reason why it may be unlikely for the Bank of Japan to actually physically intervene in EUR/JPY. With a new Prime Minister at the helm, he will be eager to prove his abilities. Boosting growth by letting the yen weaken may be an easy way to accomplish this. Furthermore, the Eurozone may not be too worried about the EUR/JPY value either. As a whole, the Eurozone region only sends 2.8 percent of its exports to Japan, which is a tiny portion of its overall exporting activities. In the history of the Euro, the Japanese have never intervened to sell Euros against the Japanese Yen, only to buy it. So if they do, it will be a monumental event. Instead, they will probably opt for verbal intervention first before even considering physical intervention. The only risk is if the US joins in the call for the BoJ to take action. They may be comfortable with a USD/JPY value below 120, but above that, they could start to become nervous. However, in contrast to Snow, Paulson has preferred a buddy versus bully approach and he may opt for a similar tactic to get Japan to strengthen its currency, like he has with China.
What to Expect from Japan's New Prime Minister
Paulson's strategy may work well as Japan's new Prime Minister has a similar goal of strengthening international relations. Despite the fact that Shinzo Abe -Japan's newly elected prime minister - has never had ministerial experience and has only been in politics for 13 years former Prime Minister Junichiro Koizumi personally groomed him to take the helm of the world's second largest economy. Unlike his predecessor, Abe's primary focus is to establish better relations with China and South Korea. He has already made a visit to China, which is the first by a Japanese prime minister in five years. Japan understands the importance of playing nice with China and South Korea, especially as tensions with North Korea escalate. This is a smart shift that will probably pay off both economically and politically. According to Hiromichi Shirakawa, chief economist for Japan at Credit Suisse First Boston, "His economic reform ideas are quite simple -- to delay tax hikes and in the meantime try to reduce spending." To that end, the departure of Mr. Abe's main rival former Finance Minister Sadakazu Tanigaki - a passionate advocate of tax increases to balance the budget - should be seen as positive sign by the currency market. If Mr. Abe is able to delay any additional tax on consumption, he will be able to provide more time for Japanese consumers to alter their frugal spending habits shaped by ten years of relentless deflation.
Deflation - Has the Battle Been Won?
The question of whether deflation has been eradicated really boils down to whether the Japanese government is willing to let interest rates rise. The government's stance, as opposed to the central bank' stance is still unclear. Brand new finance minister Omi declared an official end to deflation but Prime Minister Abe quickly corrected Omi's comments by saying that even though they are close to eradicating deflation, they have yet to official achieve that goal. Like a weak yen, a low interest rate also has a beneficial impact on the economy and it appears that Abe wants to keep rates low for the time being. Bank of Japan Governor Fukui on the other hand, is still an advocator of higher rates. Following the October interest rate meeting, he said that he would not rule out another rate hike this year. This is the same message that Fukui has been giving for some time, but we have yet to see it followed by action. If the economy does continue to improve, Abe may loosen Fukui's leash and allow for a rate hike. The growth in consumer prices have been muted, but the corporate goods price index hit a 25 year high, which means that inflation could swing either way depending upon how oil prices move.
North Korea - Still a Hotspot
Finally, another big reason why the yen has had difficult rallying is because North Korea has stirred up the markets by conducting another nuclear test in early October. Uncertainty is never good for a country's currency and unfortunately for Japan, their geographical proximity to North Korea puts them at great risk of getting involved in the conflict. So far, it is believed that North Korea's missiles only have the power to reach Japan, which means that they can be attacked. Japan has already announced sanctions on North Korea, banning trade and travel between the two countries. Japan is only a very small trade partner of North Korea's, which means that economically, the sanctions should only have a limited impact. The international community however is planning to announce wider sanctions soon. If North Korea responds by testing yet another nuclear weapon, expect the yen to continue to weaken.
Conclusion
The Japanese Yen is reaching critical support levels against most of the major currencies. Whether it breaks those levels or holds them will be dependent upon what happens first - an interest rate hike by the Bank of Japan or another missile launch by North Korea. If neither occur, the yen may begin to recuperate its losses as the weakness of the currency continues to have widespread benefits for the economy.
Technical Outlook
The USDJPY continues to rally. The rally has been choppy until recently - when the pair broke through an 8 year trendline on 10/6. The trendline was near 118.40 and bulls have managed to push the pair through the 2/3 high at 119.38. The next level of potential resistance is the 161.8% of 117.88-113.95 at 120.31. A rally past there exposes the 12/5/2005 high at 121.38. Weekly oscillators continue to slope upward and are not yet overbought. This combined with the break above the 8 year trendline favors the upside and an eventual test of the aforementioned resistance levels. Wave structure suggests that this could be the 3rd wave of a 3 wave (A-B-C) corrective move higher that began at 101.67. This would be the final leg up for the dollar which would then give way to the long term downtrend. A break of 121.38 instills more confidence in the upside and gives way to 128.61 - which is where wave C (beginning at 108.96) would equal wave A (101.67-121.38). A setback encounters support at former resistance from the 10/2 high at 118.39. It takes a break below the trendline drawn through 108.96 and 116.11 to inspire confidence in the downside. That trendline is currently at 117.00 (today on 10/11) and increases roughly 10 pips per day.
USDJPY Weekly Chart (Source: FXTrek Intellicharts)
USD/JPY Positioning
Yen speculative short positions (USDJPY long) continue to make record highs. With Yen short positions so stretched, confidence in the bullish wave pattern is not as high as it would be if positioning was more neutral. Notice below that extreme speculative Yen short positioning (USDJPY long) has preceded major tops in USDJPY. Of course, Keynes famously said that "The market can stay irrational longer than you can stay solvent." In other words, the speculative community could remain extremely short JPY for quite some time before a reversal occurs towards Yen strength.
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