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Forex: Why markets misjudged Japan

With both the stock market and currency back to levels prevailing when Japan fired off its monetary bazooka 3 months ago (having rallied 30% and depreciated 10% respectively in the subsequent 6 weeks), have markets given up on the power of ‘Abenomics’ to deliver? There are three reasons to suggest that they have not.

Firstly, markets mis-priced the timing of the impact from the policy measures. Recall that the April meeting went further and deeper than anyone had anticipated at the time. The pledge to double the monetary base means that the BoJ is currently undertaking QE at twice the pace of the Fed (adjusting for the size of the economy). Having been caught on the hop, markets adjusted to what they perceived to be the new reality. This was most apparent in the market for inflation adjusted bonds. Breakeven inflation rates (essentially the market pricing for inflation over the lifetime of the bond) for the coming 5 years increased dramatically. At one point, the market was pricing Japanese inflation to be only 20bp below US inflation. Six months previously, they were pricing Japanese inflation 140bp lower than the US. The gap is now 50bp. In summary, the market became overly confident on the ability of the BoJ’s policies to generate inflation.

Secondly, the yen believed that weakness would become a self-fulfilling phenomenon. Anticipating further weakness to come, domestic investors would place more money overseas in higher-yielding currencies. The reality has so far proven to be something different, with no strong move towards this. The yen was wrong-footed for two reasons. Beneath the weekly noise, the seasonals showed that the April/May period is not the strongest for Japanese investors to move overseas; May and December are the months with the strongest ‘home bias’. This was combined with a solid stock market performance at home, reducing the incentive for normally conservative investors to allocate funds overseas. It’s still likely to happen, but markets became overly expectant of it happening immediately.

Finally, as one of my early FX mentors often reminded me, nothing moves in a straight line, and this applies to FX more than any other market. The moves on the yen were historically very extreme. The rolling 6-month rate of change was at levels only seen during periods of global international crisis, such as late 2008, late 1998 and late 1995. A similar way of expressing the same thing would be the 26-week RSI, sat above 70 from January to May. The only time a comparable period has been seen on the yen or any other major currency over the past 10 years was the Aussie in late 2002 to early 2003.

Yes, this has occurred at a time when Abenomics itself has lost momentum, with the third (and toughest) ‘arrow’ of structural reforms not getting off the ground until later in the year, but this is a secondary consideration when set against the market moves seen above. Reform and results take time. Even 2 years is an extremely tight deadline for their inflation goal. Once markets settle, results should come (see “Delivering in Japan”), but just not as quick as markets had perhaps hoped for.

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