Deutsche – FX Daily : What’s supporting USD/JPY? FXWW

From the FXWW Chatroom – The resilience of USD/JPY has been surprising. Despite large corrections in EM assets, global equities, CNY weakness, and escalating trade tensions, USD/JPY has been supported near 110. Spot has also disconnected from its famous correlation to US 10Y yields in both nominal and real terms. One can attempt a few justifications: North Korean risk has declined after the Summit, the sell-off in US equities has been much less than in Feb, and China vol is still far from crisis levels. We control for these factors in a regression for USD/JPY to see if they can explain its stubborn level. We find that USD/JPY is still trading 3% above its short-term “financial fair value,” the largest deviation in years (Figure 1). So what is keeping USD/JPY supported? We offer two explanations:

The market has gone back to expecting perma-easing from BoJ. Negative inflation developments and improved prospects for Abe’s reelection have been behind this. Since CPI fell back in March, the BoJ has abandoned the timing by when its 2% target would be reached in April, and has downgraded their description of inflation in June. BoJ is expected to make further downgrades to inflation forecasts at their July meeting where they will also “deepen analysis and discussion on prices.” With 8 out of 9 BoJ board members believing there are downside risks to their inflation forecasts, a fuller review seems warranted (Figure 2). A dovish outcome in July would see BoJ emphasizing flattening of the Phillips curve, and concluding that persistent easing is necessary. However, this is not the only possibility. BoJ could also put weight on measurement issues in CPI, such as the absence of quality adjustments in calculating imputed rents which have held housing inflation in Japan down for years (Figure 3). If BoJ chooses to emphasize inflation drivers beyond their control, or take greater note of the side-effects of excessive easing, this would not be dovish. And while Abe’s LDP leadership bid in September looks more secure with approval ratings bouncing (Figure 4), the real contest will only begin once the Diet session closes at the end of the month.

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