The time has finally come. For the past 2 months, USD/JPY has been on a tear in anticipation of more aggressive monetary easing from the Bank of Japan. This week will be the first BoJ meeting since Shinzo Abe took office and the central bank is widely expected to cave to the Prime Minister’s pressure to increase their inflation target. Based on the fact that USD/JPY is trading at 2.5 year highs 48 hours before the monetary policy announcement, it is clear that investors expect a lot from the Bank of Japan. When expectations are high however, disappointment can be easy and in the case of the BoJ, even if they acquiesce and raise their inflation target to 2%, that may not be enough to drive USD/JPY higher considering that the currency pair already appreciated nearly 14% percent since the beginning of November.
There’s no question that Japan needs more stimulus. Since the last BoJ meeting in December, there has been more deterioration than improvements in Japan’s economy with the biggest area of concern being the country’s trade and current account deficits. Japan is an export dependent nation and having a trade deficit represents extreme deterioration in the economy but a current account deficit means that more money is flowing out than into Japan. The following table shows how the economy has performed since the last meeting and in addition to the deterioration in the trade and current account balances, the Japanese are also making less and spending less. In response, Prime Minister Abe kicked off his term with a major fiscal stimulus package but fiscal stimulus alone won’t be enough. Abe knows that monetary loosening is an absolute necessity if Japan wants to recover from their pro-longed period of sub-par growth, which is why he is so aggressive in calling for the BoJ to do more.
3 Things to Look for in the BoJ Announcement
There are 3 things that we will be looking for at this week’s BoJ decision:
1) BOJ’s Inflation Target – The Bank of Japan currently has a 1% inflation target and this means that they will keep monetary policy accommodative until the inflation target is achieved. By increasing their inflation target to 2%, they are effectively increasing their commitment to buy JGBs. To achieve this new goal, the BoJ will need to buy JGBs more aggressively and increase the length of time they had planned to be in the market. Shifting to a 2% inflation target from their current target of 1% is a given and at this point, if the BoJ does not adopt a higher inflation target, investors will take their disappointment out on USD/JPY. The currency pair will fall quickly and aggressively and drag all of the Yen crosses down with it.
2) More Asset Purchases – Aside from a higher inflation target, investors are also looking for a convincing plan of action from the Bank of Japan and a failure to deliver could crush USD/JPY. At bare minimum, the BoJ needs to increase asset purchases by another 10 trillion yen, which would probably be neutral to slightly negative for USD/JPY. What the market really wants is an open ended asset purchase program similar to the Federal Reserve’s which some have called unlimited QE. This could involve consistent purchases of 4 trillion yen a month with no end date. In order for USD/JPY to extend its gains, the BoJ would need to increase their inflation target and announce an open-ended QE program and anything short of that could hurt more than help USD/JPY.
3) Comments on Yen Weakness – We will also be looking for any comments on Yen weakness. While the Japanese economy benefits significantly from a lower currency, the speed and magnitude of the decline raised concerns that some companies in Japan could be negatively affected. If the Bank of Japan joins in the chorus of concerns, it could limit the rise in USD/JPY but we don’t believe expect anything on the currency because FX policy in Japan is the Ministry of Finance’s domain.
USD/JPY Positioning Provides Room to Upside
While USD/JPY has had a very strong rally, the latest Commitment of Traders report showed speculators cutting their long USD/JPY positions last week. This tells us that not everyone who wants to be long USD/JPY is long and therefore a positive outcome to the BoJ meeting (higher inflation target and open ended QE) could drive the currency pair even higher as those waiting on the sidelines jump back into long USD/JPY trades. If the Bank of Japan is successful in achieving a 2% inflation target, USD/JPY should be trading above 100. If they manage to get core CPI up from its current level of -0.5% to just 0.5%, it would be consistent with a USD/JPY value of 95.
BoJ Wildcard – Shirakawa
Investors may be hoping for some aggressive action by the Bank of Japan but there’s one wildcard to consider – BoJ Governor Shirakawa’s term ends in April and he could surprise everyone by snubbing the LDP and saying no to a higher inflation target or an open ended QE program. He may choose to leave the problem to his successor who will probably be someone that the LDP has in their pocket. So even if the BoJ fails to deliver this week, the long-term trend in USD/JPY is higher. Prime Minister Abe has made it clear that he wants Shirakawa’s successor to be someone who supports aggressive monetary easing which means that the BoJ will continue to buy bonds well after the Federal Reserve ends its Quantitative Easing program. Since we expect the Bank of Japan to be one of the most aggressive central banks this year, any dip in USD/JPY should be looked at as an opportunity to buy at lower levels, targeting a rally to at least 95.