Expectations for the Japanese yen

The Japanese yen remains on the ropes, but it is more than just a function of its low-yielding status. The growth-inflation mix in Japan has taken a steady turn for the worse, relative to expectations.

The thinking is that the relative growth-inflation mix has been an important driver of currency sentiment in recent months. That is, currencies that have had stronger growth dynamics relative to their inflation pressures have performed well and seem to have attracted greater capital flows.

The most obvious example has been the euro. On balance the euro area's activity and inflation data have been strong enough to keep interest expectations elevated but not to the point where investors may perceive the European Central Bank being behind the curve.

In effect, the euro area's growth inflation trade-off has been seen as generally supportive for euro area assets and hence currency supportive.

The situation in the euro area is very different from that in Japan. The latter's growth-inflation mix has been deteriorating since late January. This helps to explain why the yen is not strengthening, even though the balance of domestic inflationary pressures has been rising, especially relative to the growth data. This has seen its equity market lag behind the other performers.

The growth-inflation dynamics have even turned for the better in the US, which helps to explain why US$-JP¥ has remained elevated but importantly why US dollar negative pressure against the euro and sterling, for example, has slowed compared to a month ago.

Investors believe the growth-inflation trade-off is relatively better outside Japan and the compensation to sell the yen is still warranted. Stronger-than-expected inflationary pressures in Japan are not enough to buoy the yen.

It almost appears that the yen behaves how currencies used to trade with higher inflation data. In the past, currencies would be threatened by high inflationary pressures as it was seen as eroding the real value of a currency. The currency and inflation relationship is now very different but the yen still appears tied to the past.

While the growth-inflation dynamics may be perceived as poor in Japan and it has helped explain yen weakness, a related issue is: if global inflationary pressures start to become material, what would happen to the yen? In essence this is what could see the yen's prospects change.

Meanwhile, Japan's core CPI is expected to fall by 0.1% in 2007, as oil product prices will remain below previous-year levels through the summer and service prices are unlikely to rise, given the downturn in wages per worker.

Despite the forecast of a 0.1% drop in core CPI in 2007, interest rates could rise as long as prospects for the economy remain intact. The Bank of Japan is expected to raise interest rates by 25 basis points in August and the first quarter of 2008.

Looking at economic growth, Japan's real GDP grew by an annualised 5.4% in the last quarter of 2006 and by 3.3% in the first quarter of this year. Both these rates are well above the potential growth rate.

This strong growth and a slowdown in exports will push second quarter GDP growth downward. In the latter half of 2007, however, an upturn in industrial production and exports is foreseen, as export volume growth to Asia remain firm and US manufacturers are drawing down excessive inventories. Furthermore, personal consumption is expected to remain firm. For these reasons, forecasts of real GDP growth in 2007 have been raised to 2.4%.

For the moment, however, the yen is being partly eroded by Japan's low interest rates and weak growth inflation dynamics. However, if a scenario emerged where the market became very concerned about rising global inflationary pressures, then the yen's predicament could suddenly improve.

For example, the perception in the second quarter of last year was that many central banks were behind the curve fighting inflation.

This led to a major reduction in risk appetite, particularly in Emerging Markets (EM) currencies. This EM drawdown also saw the yen stage a broad-based rally. The belief is that if an inflation scare emerged again, the yen's prospects would improve markedly.

This would be tantamount to a significant risk reduction climate. However, the yen would likely perform even better than it did in such a period last year given how the yen-funded carry trade is more extended.

Looking at the aggregate measure of global inflation surprises during the past couple of months, the series is showing a notable comparison to May-June last year. This suggests that some caution is warranted when selling the yen just because its growth-inflation backdrop is relatively weak.

A re-emergence of global inflation concerns like last year would override the yen's current situation due to its growth inflation mix.

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