- Recession and the forthcoming general election in Japan have raised expectations of further monetary easing from the Bank of Japan (BoJ). Not least, an increase of the BoJ's inflation target from the current 1% to 3% could prompt a structural shift in the underlying appreciation trend of recent decades.
- We expect a significant weakening of JPY over the coming 6-12 months and we recommend EUR-based clients to hedge JPY income/assets via FX forwards.
- Hedging JPY-denominated income via purchases of EUR/JPY call options has become less attractive due to the rise in EUR/JPY risk reversals. Also, we expect a further decline in implied volatilities, which are still trading well above 2005-07 levels.
- However, option hedging should be considered for longer term maturities, particularly if there is large uncertainty about cash flows.
Japanese GDP contracted by 0.9% in Q3 12, so Japan seems to be in technical recession already at this stage. The economy has been hit by declining exports, which are due to slowing GDP growth in China and a historically strong yen. This has stepped up pressure on the BoJ to provide further stimulus.
Everything indicates that a new Japanese government will be installed after the general election on 16 December. Shinzo Abe, the leader of the opposition party and likely new prime minister, has long criticised the BoJ for not taking sufficient action to counter the strength of the yen. Among other things, Abe has advocated raising the inflation target from currently 1% to 2-3%.
The BoJ has previously been giving in to political pressure and has stepped up its asset purchasing programme in 2012. The current pace of asset purchases translates into annual purchases of just under 8% of GDP, which is a very aggressive pace of easing. This compares with asset purchases by the US Federal Reserve of USD 40bn per month – equivalent to 4% of GDP on an annual basis.
We expect the BoJ to continue easing at a significant pace. As such, the BoJ is likely to increase the target for its asset purchases by another JPY 10trn to JPY 76trn at the next policy meeting on 20 December 2012. The inflation target could be raised sometime next spring.
An increase of the inflation target to 3% would imply a change in the structural appreciation trend of JPY, which has strengthened at an annual rate of 2% on average against EUR over the past 20 years. However, a precondition for changing the appreciation trend is that the market is confident of BoJ being able to deliver higher inflation rates via monetary easing.