Japan takes over

After the US quantitative-easing programme ended with a whimper, a renewed stimulus package from the Bank of Japan is dominating decisions in Asia’s foreign exchange markets.

With 2015 looming large on the horizon, it is Japan that has Asia’s foreign-exchange markets on tenterhooks. US monetary policy, so long the key to global market liquidity, is playing second fiddle.

The US Federal Reserve ended its massive six-year stimulus programme in October without much ruckus. The central bank had already prepared investors for this in July, seven months after it first started trimming its bond-purchase programme, which, at the peak, had pumped US$85bn a month into the global financial system.

Fed minutes for the October meeting show little debate or dissent among policymakers as the US economy pushed ahead with above-trend 3.5% annualised growth in the third quarter, while churning out the best job gains in years. In October, the US jobless rate eased to 5.8%, its lowest in over six years, in a continued retreat from the near 10% figures in the wake of the global financial crisis.

The US economy has emerged as the star in the advanced world. Yet, the Fed has promised to hold its short-term interest rate near zero for now as falling gasoline prices keeps inflation below the 2% target, and most economists expect the central bank to wait until the middle of 2015 before lifting interest rates. For now, the Bank of Japan’s expanded stimulus is filling the void the Fed has left, while the European Central Bank is also promising to pump more money into the euro bloc if current measures fall short.

The US dollar’s strength, especially against the G10 currencies, remains Goldman Sachs’ strongest asset market view for 2015, alongside continued declines in the euro and further meaningful yen weakness. While expectations of a strong dollar are widely held, with forward markets pricing in a significant widening in US policy rates versus others, Goldman Sachs has noted there is still scope for rate differentials to widen, even versus the forward pricing. The bigger story is the dollar’s multi-year recovery, according to the bank’s analysts, who have recommended clients adopt more ambitious dollar positions.

Stephen Jen from SLJ Macro Partners has also argued that the current environment is very positive for the dollar, as it is the first time since 2009 that the Fed has pledged to keep rates low for longer in response to a positive supply shock rather than a negative demand shock, and both the near-0% policy rate countries and those facing high and rising household leverage will prefer to keep their own currencies weaker. However, Jen has warned that the yen-weakening story could overshadow the dollar’s strengthening.

“The US dollar’s strength, especially against the G10 currencies, remains Goldman Sachs’ strongest asset market view for 2015, alongside continued declines in the euro and further meaningful yen weakness.”

While Fed policy had been the wild card for most of the last two years, the tables turned when the BOJ pulled its huge Halloween surprise. Less than 24 hours after the Fed announced the end to quantitative easing, the BOJ said that it would boost Japanese Government bond purchases by ¥30trn (US$255bn) to an annual pace of ¥80trn and triple its purchases of exchange-traded funds and real-estate investment trusts.

On the same day, Japan’s US$1.2trn public pension fund – the world’s largest – announced that it was to increase holdings of foreign stocks to 25% of its portfolio from 12%, pouring around US$187bn into worldwide stock markets in the process. Meanwhile, Prime Minister Shinzo Abe has pledged to postpone a planned second increase in the sales tax if he wins the December 14 snap election.

Even weaker yen

News that Japan’s economy had entered a triple-dip recession in the third quarter provided solid rationale for the recent policy moves. A continuous stream of poor Japanese data will only increase pressure on Abe and Kuroda to pull out all the stops to get the economy going again. The yen is now hovering at more than seven-year lows after falling over 10% since the start of the year and 35% in the two preceding years.

SLJ’s Jen believes that the BOJ is unlikely to watch any technical correction in the dollar unfold uncontested, noting that policymakers in the country – as well as their peers in Europe, Australia, New Zealand and Switzerland – have all pushed their currencies lower either verbally or through actual policies.

Jen believes that Kuroda, emboldened by the board dissenters’ struggle to justify their hawkish stance, could resort to further easing before April. What is important from a market-moving perspective, however, is not if he will succeed in getting inflation back up to 2% come next April, but that he keeps trying.

Uncertainties over the outcome of the Japanese election and the finance minister’s concerns over the pace of the yen’s weakness could prevent a build p in yen shorts in the near term. However, Nomura analysts have said that the risk of a regime change is small and do not expect policymakers to intervene to prevent the yen from sliding. Rather, a ruling coalition victory will decrease political uncertainty going into 2015, strengthen Abe’s political power and boost Japanese and foreign investors’ risk appetite, Nomura says.

Meanwhile, Joyce Poon from Gavekal Dragonomics has pointed to recent policy developments as a sign that PM Abe is looking to push the yen deep into undervalued territory. Abe’s efforts have so far paid “meagre dividends” with export volumes rising sluggishly as exporters avoid cutting the foreign currency prices of their shipments to restore profitability in yen. For Poon, the only way Japan can hope for an economic boost from the export sector is to “eat its rivals’ lunch” and South Korea, the biggest loser from such a beggar-thy-neighbour policy, will be forced to respond with similar tactics.

Asian impact

The Korean Won has suffered the most in the face of a plunging yen, falling 5% against the US dollar in 2014 to 15-month lows. The Taiwanese and Singapore dollars are next with 3% declines, while the Malaysian ringgit and Philippines peso are down 1%–2%. The Thai baht, Indonesian rupiah and Indian rupee, however, have held steady since early 2014.

The Won has become more exposed to a weaker yen due to the rise in Korea’s export similarities to Japan in recent years. ANZ research has noted that Korea’s export similarity index with Japan has risen to more than 0.6, and the nation’s top 10 export categories with the strongest overlap with Japan now account for nearly half of total Korean exports.

While the export similarities between Japan and the Philippines, India and Vietnam, respectively, have also risen, they remain well below Korea’s at less than 0.4 points. An ESI of 1 indicates an identical export structure to Japan.

Every 1% fall in the yen will increase by around 0.16%–0.21% the nominal effective exchange rate for the Korean Won, Taiwanese dollar and Thai baht, according to BIS data ANZ cited, compared to only about 0.05% for the rupee.

“India is the clearest example of an emerging market that has addressed its macroeconomic imbalances and is on the right side of the oil import-export divide.”

EPFR data showed four consecutive weeks of inflows to Emerging Asia funds as of November 19. However, ANZ does not expect portfolio flows to impact the yen’s weakness through the trade channel. While the Singapore dollar could benefit from portfolio inflows, for instance, Asia accounted for only 3.1% of Japan’s US$554bn of outbound investment in 2013, according to ANZ.

Inflows into the region’s investment-grade markets were also unlikely to be large enough to have an impact on the yen, and long-term yen weakness could discourage Japanese foreign direct investment to lower-cost countries, the analysts wrote.

Investors have been positioning for the trend to continue. Short positions in the Won have risen to 2008 crisis highs, with bearish bets on the Taiwan and Singapore dollars at their highest since 2009. Investors are also turning more bearish on the ringgit, while long bets on the rupiah and rupee have been trimmed. Only renminbi bulls have held on, thanks in part to the launch of the Hong Kong-Shanghai Stock Connect trading scheme.

Credit Suisse has highlighted the growing importance of the renminbi to FX rates in Emerging Asia, noting that the yen remains a key driver for the Won, Taiwan and Singapore dollar, with some impact on the ringgit.

India, meanwhile, continues to attract support.

China’s predicament

Goldman Sachs has described India as the clearest example of an emerging market that has addressed its macroeconomic imbalances and is on the right side of the oil import-export divide.

Lower international food and oil prices have driven down headline inflation across the emerging markets, and the relief from inflation pressures should support five-year to 10-year bonds in India, according to the US investment bank. ANZ also expects the rupee, as well as the rupiah, to be the least affected of the Asian currencies on the yen’s weakness, while Bank of America Merrill Lynch has predicted that the rupee will outperform both the yen and the euro in the coming months.

China’s slowing GDP growth and deflationary risks from the yen’s weakness have spurred talk of renminbi depreciation. The Chinese unit has been rising for most of the year after selling off briefly in the first few months as the People’s Bank of China engineered a squeeze that introduced greater two-way flows. Currently, the renminbi is only 1.3% weaker from the start of the year, and the PBoC’s daily fixings for much of the second half of 2014 have suggested it remains intent on keeping the currency steady as the US dollar strengthens.

The renminbi’s move against the yen, however, has been far more remarkable.

While the yen is within the range of recent experience at around 118 to the dollar, the renminbi has surged to its strongest against the Japanese currency since late 1993. Rabobank’s Michael Every, head of Asia Pacific financial markets research, says that the 35% surge since January 2013 is hardly a gradual shift, even accounting for rapid economic development in China. Adjusted for inflation, the renminbi is trading even higher, despite the recent sales tax-related spike in Japanese inflation.

The question remains as to what China will do as the yen continues spiralling downwards. The PBoC surprised many in the market to cut one-year benchmark lending rates on November 21. However, not everyone believes this is due to concerns over the currency, since FX is managed more directly through the daily fix and rate cuts are unlikely to affect the renminbi significantly. However, some analysts say that the PBoC’s rate cut reduces the relative attractiveness of the renminbi and makes it riskier to hold.

Gavekal’s Poon says that it is diplomatically more difficult for a country with a large trade surplus, such as China, to follow Japan’s depreciation path, noting that significant renminbi depreciation could trigger large capital outflows at a time when the financial system is still fragile and marginal gains in export competitiveness small relative to the threat of domestic financial instability. From a longer-term perspective, a strong and stable unit is vital in China’s currency internationalisation.

Nevertheless, the weaker the yen, the greater the pressure on China to follow suit as its major Asian export markets allow their own currencies to depreciate. Also, if confronted with potentially dangerous capital inflows, Beijing may well decide, as it did in the first quarter of 2014, that a greater degree of downside volatility is needed to restore the market’s equilibrium, says Poon.

Rabobank’s Every has joined those warning there may be another PBoC-inspired sell-off, possibly as soon as in the first quarter of 2015. The last thing a heavily indebted country needs is to exacerbate deflationary pressures and Every sees the renminbi drifting to 6.40 against the dollar in mid-2015 before moving back towards 6.25. For Every, the PBoC may not have started this FX war, but it seems unlikely that it will be the one to lose it.

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