Business sentiment in Japan rose to a three-year high during the first quarter according to the Bank of Japan’s latest quarterly Tankan survey. A weaker yen, along with strengthening global demand, was a big factor for the optimism as the Tankan all firms index rose from 7 to 10 in the first three months of 2017 – the highest since the corresponding period in 2014.
Japanese policymakers have been struggling to boost the country’s flagging growth rate and lift consumer prices through a combination of fiscal and monetary stimulus measures. Their efforts may finally be paying off as Japan’s economy recorded its fourth consecutive quarter of expansion at the end of 2016 and annual CPI excluding fresh foods rose to a two-year high in February. However, although an ultra-loose monetary policy by the BoJ and pro-growth policies by the government have contributed in supporting the economy, a more competitive exchange rate has been the biggest boon for export-dependent Japanese businesses.
The yen is down by about 12% from its 2016 high of 98.98 yen per US dollar, but even at the 100 level, the Japanese currency was significantly below the highs of around 76 it hit during 2011-2012. The drop in the dollar in the first half of 2016, was led by declining expectations that the Fed would raise rates more than once during the year. It’s more recent slide from the December 2016 peak of 118.66 to 110.10 yen in March was partly attributed to disappointment that the Fed is sticking to its 3-rate hikes path, and partly from the unwinding of the Trumpflation trade.
The 110 level proved an important support level for the dollar during the latest downtrend, signalling the underlying fundamentals for the pair such as the rising interest rate differential between the US and Japan. It didn’t take long for short covering to push USD/JPY back above 111 yen last week after it came close to breaching the 110 handle.
However, the dollar remains vulnerable to several potential risks, mainly from the direction of President Trump’s policies. The Trumpflation rally was triggered by expectations that the new US administration would stimulate growth with massive tax cuts and infrastructure spending. The failure of the healthcare bill on March 24 raised doubts in the markets about the timing and scale of any tax reforms, or if they would even be passed. Meanwhile, President Trump continues to talk tough on trade and has ordered a review on currency manipulation by other countries as well as asked for a report aimed at identifying trade abuses.
A move by the Trump administration to adopt protectionist trade practices would likely pressure the dollar as it would be seen to be harming US and global growth. In such a scenario, the yen would not only gain from a weaker dollar but also from the added demand from safe-haven flows. This stresses the importance of Trump’s fiscal policies to the dollar’s as well as the yen’s outlook, as the potential effect of the tax and spending plans on growth would determine whether the dollar rally is sustainable in the longer run.
In the meantime, the impact of a strengthening Japanese economy on the yen should not be completely discounted as the recent run of positive data has led to most analysts to forecast that the BoJ’s next move will be to tighten policy. However, the Bank of Japan has already signalled that “it will be a considerable amount of time before the Bank will need to change its monetary policy” as inflation remains considerably below its 2% target. This means Japan 10-Year government bond yields are unlikely to rise much from the BoJ’s target of around 0% anytime soon, maintaining the considerable spread with U.S. 10-Year treasury yields.