In the fourth quarter of 2007 the Japanese yen enjoyed its best performance against the greenback in more than 2 years. For a time USDJPY even dropped below the psychologically critical 110 barrier before recovering by year end. Yen strength however was driven strictly by risk aversion dynamics rather than by any improvement in Japan’s economic fundamentals. In fact if anything Japan’s economy deteriorated materially as the quarter progressed putting any notion of a BOJ rate hike on hold for at least the first quarter of 2008 and perhaps even further beyond into the first half of next year. However, as has been the case for most of the year, traders ignored the economic news from the land of the rising sun and focused strictly on risk aversion / risk assumption dynamics. Thus as the secondary vestiges of the credit crunch spread through the system, with many US financial players reporting additional losses, USDJPY declined on risk aversion flow. Looking forward to 2008, the pair is likely to follow a similar path, but with a decidedly more bearish bias, as the relentless lowering or US interest rates by the Fed has removed most of the luster from the USDJPY carry trade. While the yen remains relatively weak against other high yielders such as the euro, New Zealand and Australian dollars, it has strengthened significantly against the greenback since its lows in June when USDJPY reached 124.00. While the Dow is only marginally off its highs suggesting relatively healthy risk appetite, USDJPY now finds itself more than 1000 points lower as interest rate differentials continue to compress. With the Fed expected to continue its easing cycle, the downward arch of the pair is likely to extend into 2008. In short, the movements of USDJPY next year will be determined almost exclusively by the events out of the US, irrespective of the Japanese fundamentals. In order to understand the reasons for this dynamic we must examine the moribund state of the Japanese economy more closely.
Tell Us Where You Think the USD/JPY is Headed in 2008 on theDailyFX Forum.
[B]Consumer in the Dumps[/B]
Perhaps nothing better demonstrates the weak state of the Japanese economy than the woeful readings of the Eco Watchers survey. This “man-in-the-street” poll of barbers, taxi drivers and waiters is our favorite gauge of Japanese consumer sentiment because it captures the up to the minute spending habits of millions of Japanese consumers. Lately its message has been unambiguously dour. In December the survey dropped to 38.8 – its lowest reading in four years as it sank ever deeper below the 50 contraction/expansion line. The news from the Eco watchers suggests that Japanese consumer confidence will remain low for the foreseeable future. Wrecked by political scandal over the mis-handling of the country’s pension plan, the ignominious exit of the former Prime Minister Abe and the persistent contraction in Labor cash earnings, the Japanese consumer is unlikely to serve as the engine of growth for the country’s economy in the foreseeable future. In fact, this consumer weakness has weighed on the Japanese service sector as the country’s Tertiary Index contracted 2 out of the past 3 months, with the latest reading showing a significant -1.6% drop.
[B]Economic Growth Wanes[/B]
Yet services are not the only soft spot in the Japanese economy. While the country’s mighty industrial sector continues to chug along, aided by strong global growth and favorable exchange rate differentials, Q3 GDP still managed to miss its mark badly. The world’s second-largest economy grew at an annualized 1.5% rate in the three months ended Sept. 30 2007 versus 2.6% projected as spending on factories and equipment fell in the quarter, and profits fell for the first time in five years. The news going forward is not expected to be much better with Q4 GDP likely to maintain the anemic sub 2% pace as export demand from US slows. The country’s most important economic survey - the TANKAN - printed at its lowest level in 2 years as energy woes and higher currency exchange rates depressed manufacturer’s outlook. While Japan continues to accumulate massive trade surpluses, the country’s export oriented structure is clearly showing its weaknesses as the economy remains vulnerable to a US slowdown while unable to generate sufficient consumer demand at home to resuscitate growth.
[B]
BOJ – On Hold Irrespective of Rhetoric [/B]
In a recent speech the BOJ Governor Toshihiko Fukui referenced Japan’s consistently ultra low interest rates when he said that, “As these very accommodative financial conditions persist, we could see a distortion in the allocation of resources in the long term that could hurt the prospects for lasting growth.’’ While Governor Fukui’s intentions to keep currency traders on their toes are commendable, the fact of the matter is that given the dismal state of current Japanese economic conditions, his options are limited. While Japanese monetary officials clearly want to keep the prospect of higher rates alive, the central bank is unlikely to make any tightening moves in the first quarter irrespective of any tough rhetoric. The markets of course sense this reality and as a result Japanese bond yields have been pushed lower. Five year JGB’s slipped below the 1.00% mark yielding as little as 99 basis points in light of the disappointing economic news. Little wonder then that domestic demand for higher yielding currencies is likely to persist as Japanese retail investors continue to seek more favorable returns overseas. However, this demand will not translate into major appreciation in USDJPY as US rates are expected to contract further, but it may instead provide strong support for those currencies whose yields are expected to rise or at least remain stationary. To that end the popular carry pairs of NZDJPY and AUDJPY are likely to appreciate far more than USDJPY if appetite for risk remains constructive.
[B]EURJPY – Risk Aversion vs. Risk Assumption[/B]
All throughout 2007 EURJPY has been the poster child for risk in the capital markets. As the predominant carry trade in the currency market it rose and fell with the gyrations of the Dow. During the sharp bout of risk aversion in August and then again in November, the pair dropped by more than 1000 points each time, but quickly regained its footing and recovered most of its losses. One of the key reasons for the pair’s resiliency has been the consistently disparate monetary policy of the ECB and the BOJ. As we have already noted the BOJ has been dormant since February of 2007 while the ECB has been relentlessly hawkish, raising rates to 4% by the end of the year. In fact, were it not for the sub-prime blowup in US and the concomitant credit crunch that it created in the global capital markets, the ECB would have very likely raised rates at its last meeting in December. Even in an environment when the Fed has been cutting aggressively and the BoE decided to reduce rates as well, ECB has remained resolutely hawkish, warning the markets about the risk of rising price pressures. As we noted in our analysis of the post ECB press conference, “The message from President Trichet was essentially, “Don’t mess with us.” Mr. Trichet focused squarely on price pressures burbling up in the EZ economy, ignoring the possible dangers of weak consumer spending, suggesting that the ECB was willing to buck the global monetary trend of easing and would hike rates if necessary in Q1. “ It is precisely this dynamic that could lead to further gains for the pair in Q1 of 2008. However, the case for the long EURJPY argument will rest squarely on the ability of global economy to continue expanding at 3% rate or better. Should global growth continue, it will provide support for equities and in turn enhance risk appetite. It will also enable the ECB to tighten rates further much as most European monetary authorities are inclined to do. Therefore, a positive equity environment and further expansion of interest rate differentials would almost certainly fuel more gain in EURJPY. However, if global growth suddenly slows and US begins to teeter on the edge of a recession, the decline in EURJPY could turn vicious. If markets suddenly become risk averse, the flow towards yen as the carry trade is unwound, it could quickly take EURJPY to 150 and perhaps even lower. This risk remains the operative factor in determining the direction of the pair as we enter 2008.
[B]Key Points[/B]
If 2007 was the year of the carry, as USDJPY reached a multi year high of 124.00, 2008 may very well be the year of the unwind. Despite the lackluster Japanese fundamentals, the directional bias in the pair appears to be skewed to the downside as the relentless compression in interest rate differentials engineered by the Fed has made the carry trade less and less attractive as time goes on. The decline in USDJPY may be further exacerbated by any sharp sell off in equities. If the slowdown scenario comes to fruition and Dow Jones industrial Average plummets to 12,000 or below USDJPY, could easily pierce the psychologically critical 100 barrier as risk aversion grips the currency market. With the BOJ handcuffed by weak fundamentals from raising rates anytime soon, the direction in the pair in 2008 will be driven almost exclusively by US economic news and by the Federal Reserve.
[B]USDJPY Technical Outlook: A Potential Test of 100[/B] – [I]By Jamie Saettele[/I]
Last quarter, we wrote that [I]“the USDJPY may have completed a 12 year correction in the form of a triangle at 124.13. The pair should be on its way towards the base of the triangle at 101.26.”[/I] Price action over the last 3 months reinforces the bearish bias. In fact, the USDJPY may be entering a 3rd of a 3rd wave down, which means that the decline should accelerate. The decline from 124.13 can be counted as a series of 1st and 2nd waves. The rally from 107.20 was a 3 wave rally, which is corrective. Risk of a larger, more complex rally is possible, but price must remain below 117.93 in order for the bearish bias to remain intact. With the minimum target not until about 100.00, reward/risk still favors bears.
