Yen Outlook and BOJ Meeting This Week

The BOJ meets at the end of the week. For good reason, no one is expecting a change in rates. The risks lie with its economic and inflation assessment. It could revise both higher. Export growth has been fairly robust in recent months and this is helping boost industrial output and capex plans.

Japan continues to be the only major industrialized country experiencing outright deflation. This was driven home earlier today as Japan reported 1.1% (year-over-year) decline in corp service prices. This was slightly better than the consensus and a minor improvement from the revised 1.2% decline in Feb (from -1.3%).

There has been some talk, however, that, as projections for the next fiscal year are made, the BOJ may forecast the end of deflation. However, just as the BOJ meets, the government will report April Tokyo inflation and the risk is that its shows the deepening of deflation. Tokyo headline CPI is expected to fall 2.2% on a year-over-year basis compared with a -1.8% pace in March. A modest increase in deflation is expected even after food and energy are stripped out.

In terms of QE, which was expanded last month, additional steps now seem unlikely. However, government pressure is likely to persist and the risk is that the BOJ may expand QE. It seems very reluctant to increase its JGB purchases (rinban operations), but the BOJ may consider lengthening the maturities of the fixed rate QE facility from 3 month to 6 months.

Meanwhile the dollar is at the upper end of its 6-7 month range against the yen. The high since last August was set earlier this month near JPY94.80. For medium term investors, we previously noted the 50 and 200 day moving average of the European currencies crossed in February, first sterling, then the euro, and finally the Swiss franc. We cited this as a signal of a change in trend. The yen was an exception among the majors. However, in the middle of last week, the dollar-yen moving averages (50 and 200 day) crossed to the upside for the dollar. They had crossed down in early September last year. The greenback subsequently fell to almost JPY84.80 in late Nov.

In terms of drivers, we continue to suggest that the risk-on/risk-off matrix has broken down. Our hypothesis is that the new matrix is really about closing the output gap and growth differentials mediated through interest rate differentials.

In terms of the dollar-yen rate, our correlation work shows a higher correlation with both the 2 and 10-year interest rate differentials over the equity market. Year-to-date, the correlation between dollar-yen and the 2-year note differential is about 67% and the just below 70% for the 10-year differentials. This compares with about 47.8% correlation with the S&P 500 and about 29% with the Dow Jones Stoxx 600 (proxy for European equities).

To illustrate the shift that we are noting, look at the correlation coefficients for 2009. The dollar-yen correlation to the 2 and 10-year differentials were 1% and 3% respectively, and 50% and 57% for the two equity indices we followed (S&P 500 and Dow Jones Stoxx 600, respectively.

The desire for a safe haven, given what is happening in Europe, may help underpin US Treasury prices and this may see the dollar stall out a bit as the upper end of its range is approached. Also, we note the reversal of the Commitment of Traders' position in the futures market. In Feb and March the non-commercials were long yen. But since the new fiscal year began , the non-commercials have reversed themselves and now have a substantial short position (-50.3k contracts). This market segment is a short the yen as it has been in nearly 3 years.