GIAPPONE 6

Forex markets: Yen: 90 is back

Downward revision for the yen’s profile. After a long phase of immobility, the long-awaited downside reversal of the yen has suddenly begun. .         


          For professional investors and advisers only


          The decisive factor in triggering the movement was the BoJ’s decision to adopt an inflation-targeting regime. But will this be enough to hold the new course?
          We revise down the yen projections (see Tab.): regaining the USD/JPY 90 level seems to be easier now.
          After over six months in the waiting, during which the yen “moved” between USD/JPY 76 and 78, the long-awaited downside reversal of the yen has suddenly begun. The decisive factor in triggering the movement was the BoJ’s decision in February to adopt an inflation-targeting regime.
          But will this be enough to hold the new course? We deem that both the choice of the new strategy, and its timing, should help keep the downside trend in place. The yen displayed strong downside resistance throughout 2011, and in the opening weeks of 2012. In this period, one of the main factors that in some instances strengthened the yen, and in some other limited or prevented its decline, was the phase of persisting risk aversion2, which traditionally enhances the Japanese currency’s role as a safe haven, as was the case in the past for the Swiss franc, and in some cases still is for the US dollar.
          However, there are two additional aspects which may at least in part justify the behaviour of the yen: (1) the dynamics and level of Japanese interest rate/government yields in relation to the United States’, and (2) the dynamics of inflation, i.e. lingering deflation.
          (1) The levels and the interest rate/yield differentials between Japan and the United States, provided a good explanation of the trend of the USD/JPY exchange rate before the global economic and financial crisis of 2008, but continued to do so also subsequently (Fig. 1).

          26032012_1

          We will consider here 2yr government bond yields, as they reflect growth and inflation prospects, as well as the correlated monetary policy expectations. Considering the period between the beginning of 2005 and now, based on (average) weekly data, a correlation of 92% emerges between the USD/JPY exchange rate and the short-term yield differentials between the United States and Japan. The estimates resulting from a linear regression of the exchange rate on differentials have good explicative capacity (fitting, Fig. 2). Proximity to zero of both US and Japanese yields, as well as the former’s upward stickiness (the Fed has committed to keeping official interest rates close to zero at least until around mid-2014), and the near-impossible prospect of the latter dropping (they cannot drop any lower than zero: the average level recorded in the first three weeks of March was 0.11%), not only significantly limited the yen’s potential downside, but also kept its fluctuations within a narrow range for an extended period of time.

          (2) On the other hand, the yen was at length pushed upwards, towards an appreciation, by Japanese consumer price dynamics in relation to US prices (Fig. 3) and, in particular, by lingering deflation in Japan. An approximate estimate of the correlation of purchasing power parity seems in any case to suggest that, although the yen followed the direction imposed by inflation differentials, lately (since shortly after the beginning of 2010, Fig. 4) it exceeded a little compared to these as well, i.e. it appreciated a little too much.

          26032012_2

          Such excessive upward bias is partially explained, as discussed above, by the rise in risk aversion on the international markets. Given these conditions, how could the yen reverse its course and start out on the long-awaited depreciation trend? Not even the BoJ, with its direct interventionson the currency markets (purchase of dollars against the sale of yen) was capable of triggering the movement. However, it did manage to contain the appreciation.
          In February, however, the coup de theatre came: the BoJ announced the adoption of an inflation targeting regime, adding that, given the need to stably restore inflation to levels above zero, it would adopt further expansive monetary policy measures. This official change in strategy, announced at the right time, i.e. (A) when foreign trade data began to outline the risk of a structural inversion of trade balances (from historically positive to negative), also because of the exchange rate’s appreciation, and (B) when risk aversion had started to ease, in step with a “definitive” solution to the Greek crisis being approached”, broke the yen’s impasse at last, and triggered the long-awaited downside reversal.
          As a result, now conditions seem to be in place in terms of (i) fundamentals, (ii) the market, (iii) and the institutional context, for the depreciation of the Japanese currency to continue.
          However, the downtrend, while clear in underlying terms, may at times prove slower and more gradual, and/or undergo interruptions due to lateral movements. It should not be overlooked that rates are close to zero both in Japan and in the United States, and that for the time being there are still no indications of them possibly breaking the deadlock for at least the next 12 months.
          In any case, it is legitimate on a one-year horizon to assume a widening of the short-term yield differential. Simulating a rise from 25bps at present to 100bos in a year (Fig. 1), using the model based on yield differentials described above, the result is that the yen may rise back to (just) above the USD/JPY 90 mark (Fig. 2). It cannot be ruled that this may take place even before then. What’s more, the fitted value yielded by the yield differentials-based model suggests that even now, at current levels, the yen is overvalued (Fig. 2: fitted value of 86.38 vs. actual value of 83.06 for the USD/JPY exchange rate), and even the purchasing power parity model already places the exchange rate at least at USD/JPY 90 (Fig. 4: estimated purchasing power parity value at 92.50 vs. actual value of 76.96 for the USD/JPY exchange rate, in the last reference month of the sample period considered).
          Lastly, the prospect of the inflation differential curve (Fig. 3) reversing its trend, albeit gradually and moderately, also thanks to the official adoption of an inflation targeting regime by the BoJ, should make a not negligible contribution to safeguarding the new trend of the yen.


          Appendix
          An
          alyst Certification

          The financial analysts who prepared this report, and whose names and roles appear on the first page, certify that: (1) The views expressed on companies mentioned herein accurately reflect independent, fair and balanced personal views; (2) No direct or indirect compensation has been or will be received in exchange for any views expressed. Specific disclosures: The analysts who prepared this report do not receive bonuses, salaries, or any other form of compensation that is based upon specific investment banking transactions.

          Important Disclosures
          This research has been prepared by Intesa Sanpaolo S.p.A. and distributed by Banca IMI S.p.A. Milan, Banca IMI SpA-London Branch (a member of the London Stock Exchange) and Banca IMI Securities Corp (a member of the NYSE and NASD). Intesa Sanpaolo S.p.A. accepts full responsibility for the contents of this report. Please also note that Intesa Sanpaolo S.p.A. reserves the right to issue this document to its own clients. Banca IMI S.p.A. and Intesa Sanpaolo S.p.A. are both part of the Gruppo Intesa Sanpaolo. Intesa Sanpaolo S.p.A. and Banca IMI S.p.A. are both authorised by the Banca d’Italia, are both regulated by the Financial Services Authority in the conduct of designated investment business in the UK and by the SEC for the conduct of US business.
          Opinions and estimates in this research are as at the date of this material and are subject to change without notice to the recipient. Information and opinions have been obtained from sources believed to be reliable, but no representation or warranty is made as to their accuracy or correctness. Past performance is not a guarantee of future results. The investments and strategies discussed in this research may not be suitable for all investors. If you are in any doubt you should consult your investment advisor.
          This report has been prepared solely for information purposes and is not intended as an offer or solicitation with respect to the purchase or sale of any financial products. It should not be regarded as a substitute for the exercise of the recipient’s own judgement.
          No Intesa Sanpaolo S.p.A. or Banca IMI S.p.A. entities accept any liability whatsoever for any direct, consequential or indirect loss arising from any use of material contained in this report.
          This document may only be reproduced or published together with the name of Intesa Sanpaolo S.p.A. and Banca IMI S.p.A.. Intesa Sanpaolo S.p.A. and Banca IMI S.p.A. have in place a Joint Conflicts Management Policy for managing effectively the conflicts of interest which might affect the impartiality of all investment research which is held out, or where it is reasonable for the user to rely on the research, as being an impartial assessment of the value or prospects of its subject matter. A copy of this Policy is available to the recipient of this research upon making a written request to the Compliance Officer, Intesa Sanpaolo S.p.A., 90 Queen Street, London EC4N 1SA.
          Intesa Sanpaolo S.p.A. has formalised a set of principles and procedures for dealing with conflicts of interest (“Research Policy”). The Research Policy is clearly explained in the relevant section of Banca IMI’s web site (www.bancaimi.com).
          Member companies of the Intesa Sanpaolo Group, or their directors and/or representatives and/or employees and/or members of their households, may have a long or short position in any securities mentioned at any time, and may make a purchase and/or sale, or offer to make a purchase and/or sale, of any of the securities from time to time in the open market or otherwise. Intesa Sanpaolo S.p.A. issues and circulates research to Qualified Institutional Investors in the USA only through Banca IMI Securities Corp., 245 Park Avenue, 35th floor, 10167 New York, NY,USA, Tel: (1) 212 326 1230. Residents in Italy: This document is intended for distribution only to professional investors as defined in art.31, Consob Regulation no. 11522 of 1.07.1998 either as a printed document and/or in electronic form. Person and residents in the UK: This document is not for distribution in the United Kingdom to persons who would be defined as private customers under rules of the FSA.
          US persons: This document is intended for distribution in the United States only to Qualified Institutional Investors as defined in Rule 144a of the Securities Act of 1933. US Customers wishing to effect a transaction should do so only by contacting a representative at Banca IMI Securities Corp. in the US (see contact details above).

          Valuation Methodology

          Trading Ideas are based on the market’s expectations, investors’ positioning and technical, quantitative or qualitative aspects. They take into account the key macro and market events and to what extent they have already been discounted in yields and/or market spreads. They are also based on events which are expected to affect the market trend in terms of yields and/or spreads in the short-medium term. The Trading Ideas may refer to both cash and derivative instruments and indicate a precise target or yield range or a yield spread between different market curves or different maturities on the same curve. The relative valuations may be in terms of yield, asset swap spreads or benchmark spreads.

          Coverage Policy And Frequency Of Research Reports

          Intesa Sanpaolo S.p.A. trading ideas are made in both a very short time horizon (the current day or subsequent days) or in a horizon ranging from one week to three months, in conjunction with any exceptional event that affects the issuer’s operations. In the case of a short note, we advise investors to refer to the most recent report published by Intesa Sanpaolo S.p.A’s Research Department for a full analysis of valuation methodology, earnings assumptions and risks. Research is available on IMI’s web site (www.bancaimi.com) or by contacting your sales representative.

          Source: BONDWorld – Intesa Sanpaolo – Research Department

          Normal 0 14 MicrosoftInternetExplorer4