Japanese yen: good prospects on the horizon

After a period of weakness, driven by the impact of high oil prices and an under-performing equity market, pressures on the Japanese yen have become much more balanced recently, and the chances of a recovery seem to be building.

Once the political uncertainty brought about by an early election (being held today) dies away, the US dollar-yen rate can be expected to resume its downward trend.

While the change in China's currency policy caused a short-lived spike in the Japanese yen, HSBC Research does not expect this to be a major factor going forward. More important are the signs of a global industrial pick-up, reduced domestic political risk, and the prospect of an eventful end to deflation.

Signs of a global industrial pick-up should prove supportive for the yen, given Japan's continued dependence on industrial exports. US growth in the second quarter of this year was characterised by strong final sales but also by weak imports and a reduction in inventories.

With imports likely to rebound in the current quarter, Japan will probably benefit. In addition, Chinese growth remains robust. Domestic economic conditions in Japan are also improving, with the continued fall in unemployment likely to support consumption going forward.

It is highly likely that, due to the US destocking and unexpected strong growth in the second quarter, the industrial cycle will pick up to both restock and to supply the US consumer with goods. In fact, the expectations are for a large rise in US retail sales due to massive vehicle sales.

When the global industrial cycle turns, the Japanese are in the best position to benefit. In the next phase of the inventory rebuild, US imports will rise massively and Japan has the potential to supply those goods. This will help the Japanese currency improve its position against the US dollar.

Possibly the most supportive factor for the Japanese yen over time would be an end to the extraordinary looseness of monetary policy that the Bank of Japan has been following for the past two years.

The easing element of this policy measure has consisted of excess supply of liquidity to the money markets sufficient to keep commercial bank current account holdings at the Bank of Japan between JP¥30 trillion and ¥35 trillion. The first sign that policy is changing would be a lowering of this target.

Recently the balances have fallen below the ¥30 trillion floor, but the Bank of Japan has stressed that this is a short-term technical move rather than a change in policy.

Nevertheless, there has been an increasing debate within the Bank of Japan on the 'exit strategy' from quantitative monetary easing, which is likely to intensify over the next few months.

Improvements in the domestic economy from falling unemployment and a revival of consumption spending should ultimately bring deflation to an end and this would be the signal for a significant change in policy.

There is no sign as yet that deflation is coming to an end. However, this will not stop the market speculating on a change in policy of the Bank of Japan in the coming months.

The final supportive factor of the Japanese yen has been the resumption of portfolio equity inflows. Net inflows fell to zero during the last quarter but have recently returned to levels seen early this year.

With the Japanese equity market still under-performing compared to other major markets, the renewed inflow may well reflect the attraction of lower relative Japanese valuations given the recent fall in the yen.

Equity flows are likely to have a greater impact on exchange rates than bond flows because they are less likely to be accompanied by offsetting hedging flows.

The forces on the Japanese yen now seem to be much more balanced and the chances of recovery appear to be growing as the global industrial pick-up supports exports and the domestic recovery bring an end to the necessity of monetary easing by the Bank of Japan.

With the US dollar now looking less secure, there could be a fall in US dollar-yen rate over the next few months.

This report was compiled by Peter Calleya, Marketing Department, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.