USD/JPY Establishes Foothold Above 110 on Japanese Growth Fears; More Gains Seen Ahead

- Yen struggles after Japanese economy contracts in first quarter

- Dollar bulls are back in the driving seat and more gains expected

- 115.00 possible says one analyst

- Mounting geopolitical risks overshadow rally and could provide a spoiler to outlook

© Goroden Kkoff, Adobe Stock

The Dollar-Yen exchange rate peaked at 110.45 during overnight trading and although it has since come off its highs - one Dollar buys 110.15 Yen at the time of writing - the establishment of a foothold above 110 is transformative, as it suggests the short-term uptrend is extending.

The pair's climb is surprising as it flies in the face of what would normally be expected under such market conditions. 

The Yen has a reputation for gaining during periods of risk-aversion in financial markets often as a result of rising geopolitical tensions, and yet despite simmering trade war fears between the US and China, North Korea's decision to pull-out of peace talks with South Korea and warnings future Korea-US talks might be abandoned, the Yen has not gained.

One reason for the Yen's recent weakness, even in the face of rising geopolitical risk, could be a surprise fall in growth at home.

Data out early on Wednesday morning showed the Japanese economy surprisingly shrunk by -0.2% in Q1 when analysts had expected it to only flatline at 0.0%.

This was also much lower than the previous Q4 result of 0.4%, which itself was revised down to only 0.1%. It was the first contraction in two years.

"The Japanese economy became the latest major economy to disappoint expectations at the start of this year. It provides a further negative for the Yen in the near-term," says Lee Hardman, currency analyst at MUFG.

But the weak Q1 growth result did not just weaken the Yen it also arguably boosted the Dollar, at the same time.

Back in 2017 the Dollar lost ground due to expectations that the 'Rest of the World' (RoW) would catch up with America, both in terms of growth and higher interest rates. The weak Japanese GDP print, along with weaker Q1 rates of growth in Europe and other parts of the world, however, has put the final nail in the coffin of the idea of a 'RoW' effect pressuring the Dollar lower, indeed, the Dollar may even have actually gained as a result.

Japan continues to use emergency monetary policy measures such as QE and 'yield-curve targeting' to help stave off the perennial risk of deflation. In addition, the base interest rate is one of the lowest in the world at -0.1%.

The negative interest rate is a headwind for the Yen because a low-interest rate reduces the attractiveness of Japan as a destination for foreign capital flows, since the low return investors can hope to get is a disincentive.

In fact, it makes the Yen the ideal currency to borrow in and invest in higher interest rate jurisdictions, a common currency investment practice known as the 'carry trade'.

Yet analysts have been warning that this state of affairs cannot last indefinitely and that the Bank of Japan (BOJ) will soon start to remove the extraordinary stimulus measures it has introduced, raise interest rates and 'normalise' policy. The bank would probably not raise interest rates until it had removed the emergency measures - thus the road to positive interest rates is a long and arduous one.

Expectations of more normal interest rates in Japan were part of the RoW thesis which drove an appreciation in the rest against the Dollar in 2017, however, the just-released, lower growth stats for Japan now make it less likely the BOJ will start to normalize rates as early as expected.

Japanese inflation data, released on Friday, May 18, May be pivotal in this regard as a lower-than-expected result then would be the coup-de-grace for BOJ normalisation hopes.

"First, really bad Q1 GDP data (-0.2% qoq) this morning, all we need now is weak inflation data on Friday, then everyone should realise why the Bank of Japan (BoJ) is keeping schtum about a “possible exit”," says Antje Praefcke, an analyst, at Commerzbank. 

She forecasts a high probability of a rise to 115.00 for USD/JPY as a result of the lower chances of the BOJ relaxing its easing grip.

Expectations of heavy selling at 110.00 now seem gauche in light of emerging facts.

Swiss bank LGT have told clients they are now looking for exchange rates of over 110 USD/JPY as an opportunity to reduce exposure to the greenback in anticipation of a Yen recovery, the call is at risk of becoming redundant in light of the poor Q1 GDP result.

LGT say they are basing this call on the potential of the BOJ to "surprise" markets by reducing its emergency stimulus measures, in contrast to the US Federal Reserve, "which has more or less already laid its cards on the table with regard to further monetary policy."

Yet today's data now substantially diminishes the case for a surprise move from the BOJ and we question whether LGT will be as keen to short the Dollar at 110 as they were before.

Finally, the Yen also faces headwinds from the trend for Japanese investors to search further afield for investment opportunities, which has seen increasing outflows into foreign assets, according to Freya Beamish, the chief Asia economist at Pantheon Macroeconomics.

A combination of increasing scarcity of local government bonds which the BOJ is hoovering up to practice QE and rising hedging costs means the outflows are increasingly 'naked' and therefore more of a burden on the exchange rate, says the economist. 

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