BOJ in Wait and See Mode; Here is Why

Japan reported some disappointing data, but the BOJ is unlikely to move when its 2-day meeting concludes on Tuesday.  Surveys suggest the expectations for additional easing have been pushed from Q2 into Q3.  This will allow officials time to assess the impact of the retail sales tax increase and the ongoing efforts to bolster inflation. 

It is possible that the current account deficit, which widened to a new record deficit of JPY1.59 trillion, peaked in January.    Seasonal patterns shift from a headwind to a tailwind in February and March.  The Lunar New Year may have also exaggerated the extent of the deterioration.

Nevertheless, the fourth consecutive current account deficit raises concern about Japan’s ability to fund is deficits internally.  Previously, it was able to fund its budget deficit and service its debt through domestic savings, topped up by the trade and investment income surpluses.   The household savings rate has fallen, and the trade surplus has turned into a large deficit.  In fact,  although many speak as if the US tapering is the only global financial development of note, the switch in Japan from a trade surplus to a trade deficit and the weakening of the yen are also significant changes to international investment climate.

One of the important drivers behind the reversal of Japan’s external account has been the shutdown of Japan’s nuclear energy capacity.  This month is the third anniversary of the earthquake, tsunami and nuclear disaster.   Our contacts previously intimated that the government was still aiming to complete inspections to get a few nuclear plants operational around mid-year.  Although there is some high level political opposition (reports several former prime ministers are leading the pushback), the Abe government is likely to push ahead. 

The disappointing GDP is hard to suggest mitigating factors.   Q4 13 growth was revised down to 0.2% (quarter-over-quarter), matching the Q3 pace.  Bolstered by Abe’s first arrow, fiscal stimulus, the world’s third largest economy expanded by about 1.0% in Q1 and Q2 last year.  

 If there is a consolation, it is that Q1 growth should bounce back if households step up their purchases of big ticket items ahead of the retail sales tax increase at the start of Q2 and the beginning of the new fiscal year in Japan.   Still, that will simply borrow from Q2.

The missing element is demand.  Foreign demand has not improved as much as one might expect given the depreciation of the yen.   The increase primarily reflects the depreciation of the yen. In volume terms, exports growth is miniscule.  Domestic demand is tepid.  The 0.4% increase in Q4 matches the average over the past eight quarters.  

Part of the problem is that the Japanese household is being squeezed.  Inflation has risen faster than the rate of return on their savings.  Their purchases are soon to be taxed at an 8% rate rather than 5%.  Their wages are also not keeping pace with inflation.   That said, in recent weeks, a couple large Japanese corporations (e.g.  NTT and Nippon Steel) have increased base pay, but these are the exceptions that prove the general rule.  Japanese businesses are not sharing with their employees the windfall profits spurred by the yen’s depreciation.

Business is not only an obstacle to Abenomics in terms of base pay increases, but also in terms of domestic investment.   In Q4, business investment was revised down to 0.8% from the initial estimate of 1.3%.   It has improved but remains tepid.  To the extent Japanese business are expanding capacity, it is not in Japan, but in Southeast Asia and the US. 

Bank lending had trended high through most of the 2011-2013 period, but the momentum has stalled here in Q1.  Banks reportedly are struggling to find domestic lending opportunities.   Businesses are savings-rich and have little need for fresh borrowings.  

Given the BOJ buying about $75 bln of assets a month and the currency depreciation, the diversification of Japanese savings overseas has been rather subdued.    Using weekly MOF portfolio flow data, Japanese investors bought a JPY113.5 bln worth of foreign bonds a week in 2011.   In the first half of 2012, well before Abenomics was anticipated, Japanese investors bought a weekly average of JPY200 bln of foreign bonds.  For all of 2012, the weekly average was JPY314 bln.   In 2013, the weekly average fell to -JPY46 bln.   This year’s weekly average through February is -JPY401 bln. 

While Japanese commercial banks appear to be the featured sellers, security houses and trust banks have been net buyers of foreign securities recently.  They have reportedly been particularly keen on buying US high yield products and US REITs.  This likely reflects retail interest and some may link it to the new investment scheme (NISA). 

In considering the outlook for the dollar-yen exchange rate, we typically emphasize two variables, 10-year US-Japan interest rate differentials and the equity market performance.  Presently the 10-year differential is near 215 bp.  This is the middle of the range.  The premium rose to 230 bp at the end of last year and with a brief exception has remained above 200 bp for since the beginning of November.   The US premium has not been above 250 bp since the crisis began.  In comparison, from 1995-2007, the premium rarely dipped below 250 bp. 

 

As we have previously noted, the dollar-yen exchange rate is more closely correlated (60 day rolling basis on percent change basis) with the S&P 500 (0.71) than the Nikkei (0.25).    What this also reflects is the breakdown of the break down in the correlation between the S&P 500 and Nikkei.  The correlation has been halved over the past six months to stand near 0.17 currently.   

Even running the correlation on levels, the de-coupling is evident. The rolling 60-day correlation on the level of the Nikkei and level of the S&P 500 is about 0.24 presently.  At the end of January it was near 0.88 and was never below 0.52 last year.  

Lastly, we note that the implied 3-month volatility of the dollar-yen pair is flirting with its lowest levels since the Japanese election was called in late 2012.   The implied vol now is near 8.55%.  Low volatility of the yen is one of the features of an attractive carry climate (wide and stable interest rate differentials the other main features).