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Japan Macro Watch
USD/JPY: Buy-on-dip cycle to continue; 115-
120 by end-2017
14 November 2016
Buy-on-dip cycle continues
While we had acknowledged the risk of the “final JPY strength” this autumn on the BoJ's
limit and US elections, it has been our view that the USD/JPY’s dips was to be bought as
the 100-105 level was where medium-term directional risk was likely to reverse to the
upside (Dollar’s 100 Yen risk 02 March 2016). In our view, a Republican sweep would
first lead to JPY strength on risk aversion, but eventually be the most bullish outcome for
the USD/JPY. The price action last week – a shallow dip – tells us two things about the
USD/JPY. First, the view that a GOP sweep would boost the USD/JPY was probably more
widely shared than we had thought, so a dip failed to stretch. Second, there may be
more potential USD/JPY buyers than sellers, which is in stark contrast to last year, when
there were many more potential USD/JPY sellers than buyers (Case for a stronger yen in
2016 18 December 2015). The “buy-on-dip” cycle in USD/JPY is likely to continue as we
expect the pair to reach 115-120 by end-2017. We remain constructive about Japanese
equities and see banks, insurance continue outperforming REITs near-term.
Investment Strategy
Japan
Shusuke Yamada, CFA >>
FX/Equity Strategist
Merrill Lynch (Japan)
+81 3 6225 8515
shusuke.yamada@baml.com
Paul Ciana, CMT
Technical Strategist
MLPF&S
+1 646 855 6007
paul.ciana@baml.com
Higher US rates (esp. if steepening) to boost USD/JPY
USD/JPY performs best at the time of UST bear-steepening as better risk sentiment
reduces the JPY’s safe haven demand and a wider yield spread increases the USD
demand from Japanese investors (Exhibit 2). For our US strategists, the clean sweep
means fiscal easing and higher rates, supporting their higher real rate view (A win for
bond bears and USD bulls 09 November 2016). The USD/JPY has recently tracked real
yield spread closely (Chart 1), and the pair is gradually producing higher carry as
monetary policy is diverging between the US and Japan (Chart 2). In Japan, fiscal easing
is also a possibility in light of reduced odds of TPP implementation and a potential early
snap election. Any positive impact of Japanese fiscal easing on growth is likely to
manifest itself in higher inflation expectations under the BoJ’s yield-targeting regime,
which means Japanese real interest rates can actually fall.
Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com
Watch Abe-Trump meeting – coordination or conflict?
Given the high uncertainty, clarifications on Trump’s policies on trade and currency will
be important for the Japanese market going forward. A potential Abe-Trump meeting in
New York this Thursday (17 Nov), as reported by Japanese media, warrants attention. We
suggested that Trump presidency could potentially reduce flexibility of Abe's political
and diplomatic strategy, reduce positive market risk from Japanese politics, and increase
negative risk from Japan's national security. But this is not known until we see actual
Trump presidency. If the President-elect shows an understanding for the existing Japan-
US alliance and refrains from protectionist rhetoric, it could reduce concerns about
deterioration of the bilateral relationship, supporting USD/JPY and potentially exporter
shares (though reduced odds of TPP implementation is unlikely to change drastically).
Trading ideas and investment strategies discussed herein may give rise to significant risk and are not
suitable for all investors. Investors should have experience in FX markets and the financial resources to
absorb any losses arising from applying these ideas or strategies.
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Refer to important disclosures on page 6 to 8. 11686246
Timestamp: 13 November 2016 06:10PM EST
Chart 1: USDJPY vs yield spread
1.4
130
Chart 2: USDJPY carry* gradually inching up
135.0
0.50
1.2
125
125.0
0.40
1.0
120
115.0
0.30
0.8
115
105.0
0.20
0.6
110
95.0
0.10
0.4
105
85.0
0.00
0.2
100
75.0
-0.10
0.0
95
Nov-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16
US-Japan 10yr real yield spread (LHS)
USD/JPY (RHS)
Source: BofA Merrill Lynch Global Research, Bloomberg
USDJPY (RHS)
Source: BofA Merrill Lynch Global Research, Bloomberg
*Using 3m deposit rate
USDJPY carry / 3m implied vol (RHS)
JPY sellers > JPY buyers
While uncertainty is high, what is more certain is that there are more potential sellers of
JPY than its buyers. This is the opposite of the situation some months ago (USD/JPY’s
downside risk to 110 – sell on rally 10 February 2016). First, CFTC speculative position
remains yen long though short-term traders are probably positioned for the upside
already (Chart 3). Second, we believe domestic activity to raise hedge ratio has run its
course as the USD/JPY swept through the sensitive level this year. As 2HFY16 (Oct ‘16-
Mar ‘17) has started, most life insurance companies are reportedly inclined to increase
exposure to unhedged foreign bonds though they generally remain price sensitive. In our
view, this is reflected in the USD/JPY’s consolidation during Tokyo trading hours after
the pair hit 100 on the Brexit vote (Chart 4). The fact that USD/JPY has failed to break
100 multiple times since then suggests the market looking for USD/JPY’s dip, light
positioning, and the market’s judgment that USD should be more expensive than 100
JPY. The market is probably more vulnerable to the USD/JPY’s upside than downside.
Chart 3: CFTC non-commercial futures position (bln USD)
5
0
-5
-10
-15
-20
EUR GBP CHF CAD NZD AUD JPY
Nov '15 Nov '16
Source: BofA Merrill Lynch Global Research, Bloomberg
Chart 4: USD/JPY cumulative % change by trading zone
During Japan Trading Hour(8am-4pm Tokyo)
% GOP
6
4
2
NY Hour (0am-8am Tokyo)
London hour (4pm-12pm Tokyo)
sweep
0
-2
-4
-6
-8
-10
-12
-14
-16
-18
-20
Brexit
-22
Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16
Source: BofA Merrill Lynch Global Research, Bloomberg
Technical: constructive
Daily overbought momentum (RSI) is overall a positive for USD/JPY’s uptrend.
Overbought conditions can persist longer in uptrends, but at some point this could
2 Japan Macro Watch | 14 November 2016
reverse. Fading high 106’s could be a short-term profit-taking view, or area to enter
countertrend short. A final thrust toward July highs of 107.49 is possible and an
alternative profit-taking level. A pullback to 105.50 or 104.30 could certainly be bought
for the broader uptrend targets of 108.47, and possibly 111.40, from the weekly chart
pictured here.
Exhibit 1: USD/JPY weekly chart
Source: BofA Merrill Lynch Global Research, Bloomberg
Long-term picture: 50m average crossing 200m average
Chart 5: USD/JPY monthly chart with 50m average and 200m average
210
190
170
150
130
Golden cross
110
90
70
50
Oct-91 Oct-96 Oct-01 Oct-06 Oct-11 Oct-16
USDJPY 50m mva 200m mva
Source: BofA Merrill Lynch Global Research, Bloomberg
Japan Macro Watch | 14 November 2016 3
Higher yields leading to bank, insurance outperformance
over REITs
The Japanese equity market correction managed to last just for one day after the US
election. The insurance sector has been the best performer since the US election on the
back of a steeper US Treasury curve and higher rates. Michael Hartnett observes
“violent rotation out of deflation to inflation plays”, including a move from REITs to US
banks. This should apply to Japan, where banks and insurance have underperformed
REITs amid relentless fall of the long-term yield and introduction of negative interest
rate by the BoJ (Chart 5). The domestic policy condition has changed, however, as the
BoJ is now reluctant to cut rate as it pays greater attention to the health of the financial
institution. The BoJ now intends to prevent the yield curve from flattening excessively.
While higher foreign yields may not lift yen rates as the BoJ controls the 10-year sector,
reflationary environment outside Japan at least reduces the risk of a deeper cut at home.
Outperformance of Japanese equities at the time of UST bear steepening has
historically been led by cyclicals, banks and insurance (Exhibit 2). David Gleeson is
cautious about REITs, while Futoshi Sasaki is constructive on banks. The move can
stretch further near-term.
Exhibit 2: US Treasury curve (2s10s) move and market performance (past 43 quarters simple average, %) – USD/JPY, Japan equity (local ccy term), and Japanese cyclical, bank,
insurance tend to outperform at the time of UST bear-steepening
USDJPY
Dollar
index
(DXY)
MSCI
Japan
MSCI
Japan /
ex Japan*
Japan sector*
Discretion
Financials Materials
ary
IT Industrials Energy Telecom Staples Utilities
Health
care
Bear steep 4.12 -0.60 8.58 3.32 11.68 9.97 9.96 9.46 8.58 5.88 3.27 2.86 2.83 1.89
Bear flat 1.90 0.31 3.88 0.58 3.49 -0.44 5.44 4.09 3.88 4.26 3.66 2.34 -0.06 5.21
Bull steep -1.85 -0.35 -2.32 -2.76 -3.03 -2.44 -4.70 -4.22 -2.32 -3.46 2.44 1.44 -3.64 -0.47
Bull flat -4.49 1.26 -7.31 -5.05 -8.91 -11.10 -9.94 -8.23 -7.31 -9.61 -0.37 -1.50 -4.16 -1.59
Source: BofA Merrill Lynch Global Research, Bloomberg
Used Bloomberg Treasury yield index.
Curve movements defined based on 2yr move (up or down) and 2s10s move (up or down) so these include twist movements, but even if we exclude these, implications for USDJPY and Japan equity do not change
significantly.
11 quarters of bear steepening = average 16bps increase in 2yr yields and 33bps 2s10s steepening; 10 quarters of bear flattening = average 26bps increase in 2yr yields and 20bps 2s10s flattening; 10 quarters of bull
steepening = average 48bps decline in 2yr yields and 28bps 2s10s steepening; 12 quarters of bull flattening = average 27bps decline in 2yr yields and 30bps 2s10s flattening
Japan / ex-Japan = MSCI Japan / MSCI Kokusai ratio
Japanese sectors follow MSCI definition
Chart 6: If inflation, rates surprise to upside, Japanese banks likely to outperform REITs
2.3
2.1
1.9
1.7
1.5
1.3
1.1
0.9
0.7
0.5
Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Nov-16
Bank/Reit
Source: BofA Merrill Lynch Global Research, Bloomberg
4 Japan Macro Watch | 14 November 2016
3 risks – reality vs hope, higher yields, politics
The biggest risk to our view is that actual US fiscal easing turns out to be minimal. But
we believe the USD/JPY’s move will be quicker than whatever reality emerges in coming
months. China’s unexpected RMB devaluation or any explicit rhetoric to guide USD
weakness by the new US administration could eventually trigger significant JPY strength.
The other risk is a rapid increase in US long-term yields triggers risk-off trade,
supporting Japanese yen. However, we believe a potential correction in US equity is
unlikely to reverse the medium-term direction of USD/JPY (though it could cause a
short-term pullback as our technical analysis suggests) because higher yields and
USD/JPY are backed by fundamentals for now –prospect for fiscal easing. Finally, politics
is a significant concern. The President-elect has previously criticized the Japan-US
security alliance. A shift away from the Japan-US security alliance could lead to higher
geopolitical risk for Japan. It could also lead to more defense spending and expansion of
Japanese military capability and could lift prospect for fiscal expansion. A combination
of higher geopolitical risk and defense spending is probably less bearish USD/JPY than
Japanese equities.
Japan Macro Watch | 14 November 2016 5
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Japan Macro Watch | 14 November 2016 7
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8 Japan Macro Watch | 14 November 2016