Strong economy
The state of the global economy and global monetary policy will be discussed heavily when the board members of the BoJ meet on Wednesday. On the one hand, Fed easing could add pressure on the BoJ to ease in order to avoid a further strengthening of the yen. On the other hand, easing abroad could give some relief to the global economy, which would ease the pressure on the (Japanese) manufacturing sector and on the safe-haven yen. There is no doubt that the BoJ will follow market reactions to the Fed's decision on Wednesday closely.Manufacturers have struggled but the sector PMI index has held up, hovering between 49 and 50 since the beginning of the year. Industrial production is down 1% yoy, a minimal contraction in a global perspective. However, the domestic economy has been solid and GDP growth has surprised on the upside in H1 with an average annual growth rate of 1¾%.Like the Fed, the BoJ has to consider whether the good fortune could be turning. The nominal effective yen is up 8% yoy, which continues to add pressure on Japanese exporters by eroding competitiveness and it weighs heavily on prices of imported goods. So far, the deflationary pressure has not materialised, but it is likely to do so in coming months if the surge in the yen is not broken and global deflationary trends continue.
Signals from board members still indicate some patience
At the last policy meeting in end-July, Kuroda mentioned the possibility of pre-emptive easing and said, " We will take policy action without hesitation, if necessary to avoid the risk of prices losing momentum" . Since then and after the trade war intensified and the yen surged, we have seen three board members, including Kuroda, on the wires.
Goushi Kataoka, the board's super dove, gave a speech where he stressed that the need for additional easing is heightening - no surprise here. He also mentioned the side effects of further easing as something to watch for and he has not decided whether he is going to put a proposal to cut the short-term rate to a vote. Hitoshi Suzuki, a former commercial banker who is probably the most hawkish in the nine-member board, sees no need to ease further. He is afraid that if bank deposit rates effectively turn negative, it could hurt the economy by cooling consumer sentiment.
Kuroda has been quoted as saying that cutting rates further into the negative zone is always an option. He still stresses that the side effects of further easing must be assessed. According to “sources”, BoJ policymakers are growing less confident about an early pickup in global growth and may be more open to debating additional easing. Overall, the nettakeaway from the communication over the past month does not indicate a strong sense of urgency. This indicates to us that the BoJ is still leaning towards a wait-and-see mode, but the board is likely to be more divided from now on. We could see the dovish deputy governor Wakatabe call for easing.
Still not the time
We expect the BoJ to remain in wait-and-see mode. Japan’s economy is in good shape. The unemployment rate actually hit its lowest level since 1992 in July and the labour market is historically tight. Even if this does not spur inflation currently, it is nonetheless the channel that the BoJ is counting on to make it happen. Potential policy action depends largely on the outlook for the global economy right now. Our base case is that we get a “muddling through” scenario for the global economy and high level trade talks between the US and China do not escalate tensions further. But there is a likely scenario where it will be more risk off in markets. In that case we will see further yen strengthening and the BoJ will have to respond in OctoberOn 1 October, the VAT-hike is implemented. There is plenty of room for the economy to lose momentum if the global economy keeps souring. With limited tools left at the BoJ’s proposal, we think the BoJ will remain patient, though, also considering how fiscal policy continues to be heavily expansionary. We could see a tweak to the forward guidance. This would be a “cheap” way of doing something and once again try to signal that the BoJ is ready to act. However, there is a risk that coming to the table while not really delivering anything will backfire, as markets might interpret it as a confirmation that the BoJ is indeed powerless to counter a further escalation of the global downturn.The 10-year rate target is another way to adjust the policy stance. The 40 basis point range around the target has already been breached and Kuroda has signalled that it should not be taken too literally. The range could be widened, but this would only open the door for the market to test even lower levels, which is probably not an attractive outcome for the BoJ considering recent tapering in the 5-10-year segment in an attempt to steepen the curve
USD/JPY to be driven by external conditions, not BoJ
Once upon a time, we did see USD/JPY on a trend for higher levels. But that’s long gone these days. What did work, however, was the combination of Abe & Kuroda back in 2012- 15, when they managed to depress Japanese real yields by over 200bp.
But since 2015-16, the BoJ has not been willing to compress real rates further. Today, USD/JPY is driven by US real rates. By extension, credit spreads and inflation expectations determine USD/JPY in the short run, see chart. In our view, the BoJ will not be coming back to the table to change that significantly.
The BoJ may be shifting towards a discussion of easing and action may be coming closer. In practice, we view any adjustment as something along the lines of a one-and-done rather than the beginning of continued easing which would need to be priced in the currency. In turn, USD/JPY would continue to be determined by global, rather than domestic, monetary conditions.
In our view, USD/JPY is headed towards 105 or lower in the coming months. To change that view, we will need to see a substantial change in external conditions.