Yen Drivers and CPI

Japan reports April CPI on Friday. The national headline rate is expected to be 0.4-0.5% after the 0.5% reading in March. This was the highest since November 2008. The BOJ's target is 1%. No one really expects the target will be achieved in this year or next. The fall in commodity prices and the rise of the yen (nearly 8% on a trade weighted basis since mid-March) warns that deflationary pressures may be rekindled.

Tokyo reports May inflation figures and the headline rate was last positive (0.1%) on a year-year-basis in July 2011 and before that November 2010 (0.2%). Price in Tokyo are expected to have fallen by 0.3%, the same pace as in April.

BOJ Governor Shirakawa seems to be in no hurry to take more aggressive steps to ensure that the inflation target is reached. The BOJ passed on the opportunity earlier this week. It did not even lengthen the maturity of the bonds it is willing to buy after banks failed to sell it the amount of 1-2 year notes it was committed to buying. 

He noted the upward revisions to the economic assessment and suggested that the battle against deflation will be fought with its current asset buying program. Nevertheless, should the positive national inflation figures begin trending down, and the economy weakens, an extension of the current asset purchases program cannot be ruled out.

The yen itself appears to be driven by the general investment climate. The downgrade of the sovereign rating did not have much more than momentary impact on the yen. The knock-on effects of the European debt crisis seems to be the single large factor driving the yen. 

Like Shirakawa, we often find the yen correlated with 2-year interest rate differentials with the US. As the interest rate differential narrows the yen tends to strengthen and vice versa. That correlation (60 day) stands at about 0.78 presently). The small interest rate differential (19 bp) means that that the smallest incremental move is deceivingly large in percentage terms, we ran the correlations on the level. In absolute terms the interest rate differential is just below 20 bp, which is near a 2-month high.

To look at the yen's relationship to the risk environment, we reviewed the yen's correlation with the US S&P 500, the proxy for risk assets. The yen is inversely correlated with the S&P 500 (60 day percentage change) at -0.43. This is the greatest inverse correlation since September 2010.

Since methodologically we conducted the correlation with interest rate differentials on levels and the correlation with the stock market on percentage change basis, the two are not directly comparable. However, to satisfy inquiring minds, we found that yen's correlation with the 2-year spread on the percentage change basis is about the same as with the S&P 500 (~0.44). 

The dollar found support near JPY79. The dollar has spent little time over the last few weeks above JPY80. The dollar has not finished the NY session above its 20-day moving average since the end of March. It comes in now around JPY79.80.