Fundamental Forecast for Japanese Yen: Bearish

- Manufacturing Shows Signs of Weakness as Fiscal Boost Wanes
- Bank of Japan Announces New Lending at Special Policy Meeting
- Third-Quarter Capital Spending Falls by Most on Record
- Japan to Announce New, Budget and Yields Neutral Stimulus Plan

The Japanese Yen was the worst performing currency against the US Dollar in the aftermath of a shockingly upbeat November US jobs report, losing 2.5% on Friday alone and registering a 4.5% decline on the week. More of the same is likely ahead as the Yen reclaims the dubious honor of the markets’ favored funding currency.

The US Dollar overtook the Yen as the vehicle of choice for investors looking to finance purchases of high-yielding currencies by borrowing cheaply in low-yielding ones (the “carry” trade) as the Federal Reserve ultra-loose monetary policy pushed the cost of short-term loans in USD below those in JPY for the first time in 16 years, helping to perpetuate an inverse relationship between the greenback and the spectrum of high-risk, high-return assets (stocks, commodities, FX carry trades).

This link broke down as November’s US Nonfarm Payrolls report unexpectedly revealed a meager 11,000 drop in employment and a lower jobless rate. Past experience suggests the Federal Reserve typically waits for labor markets to show durable signs of improvement to begin raising interest rates after a recession; while it is certainly premature to say that the employment situation is firmly on the mend after a single month data, November’s wildly better-than-expected outcome is enough to force the markets to re-examine what is priced in for US monetary policy. In fact, the Fed has been quietly unwinding the unconventional portion of its loose monetary stance, ending the purchases of US Treasuries and reducing those of agency debt. While these actions do not have the attention-grabbing power of a rate hike, they are certainly incremental steps in that direction.

Meanwhile, Japan seems to be on a path to more rather than less expansionary policy of both the fiscal and the monetary variety. Indeed, the Bank of Japan announced 10 trillion yen in new lending at an unscheduled policy meeting last week while the government is preparing to announce between 4-8 trillion in new stimulus. The Ministry of Finance has been adamant about keeping lending rates in check, assuring the new plan will not be funded with new debt issues and endlessly prodding the Bank of Japan not to end its asset-buying programs.

On balance, all signs seem to point to (at least) medium-term losses for the Japanese Yen. The markets must now come to terms with simultaneously emerging upward pressure on US interest rates and a concerted effort by Japanese authorities to drive the cost of borrowing in Yen as low as possible. This realignment should see a shift away using USD as a funding currency in favor of a return to the more traditional short-JPY carry trade, spurring decoupling of the stocks/USD relationship and sending the Japanese unit lower.

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