Yen shows limit of negative rates by wiping out BOJ drop in days

[NEW YORK] Traders are reminding the Bank of Japan of the limits of monetary policy in weakening a currency.

With the ink barely dry on the central bank's Jan 29 commitment to implement negative interest rates, the yen has already undone all of its 1.9 per cent drop that day and measures of purchasing power parity show the currency is still far from expensive. Commonwealth Bank of Australia is recommending its clients use options to bet on yen strength and Societe Generale SA's Kit Juckes says he'll favour bullish trades if the currency holds firm.

Japan is just the latest example of policy makers hamstrung by the fundamental drivers of currencies as they try to protect economic growth and boost inflation. The yen, like the euro, is in demand as a haven from market turmoil, bolstered by its current-account surplus.

On the flip side, outflows of capital seeking greater returns abroad have dried up, removing one factor behind the currency's drop to a 13-year low in June.

"This is a super-weak yen already," said Alan Ruskin, global co-head of foreign-exchange research at Deutsche Bank AG in New York. "The incentive to invest abroad when your exchange rate is extremely weak, and has the potential to strengthen in the long term, is such that you've got to be very careful."

The yen has strengthened 2.8 per cent this week to 117.90 per dollar as of 5 pm in New York on Wednesday, taking it back beyond the level before the BOJ's decision.

Analysts raised their year-end forecast for the currency to 124, from 125 before the BOJ meeting, according to the median estimate of analysts surveyed by Bloomberg.

It's still 13 per cent undervalued against the US dollar, according to an Organization for Economic Cooperation and Development measure of fair value. Now, the resistance to further declines is a threat to the BOJ's plans to revive inflation.

POLICY MAKERS

Policy makers have already pushed back their deadline for reaching 2 per cent inflation three times in less than a year, dealing a blow to Prime Minister Shinzo Abe's plans to revive the world's third-largest economy through a combination of monetary easing, government spending and business deregulation. In the end, the BOJ may need to settle for a stable currency as the best it can hope for, according to SocGen.

"Keeping the yen here is a Sisyphean task," Juckes, a London-based global strategist at SocGen, said in an interview in Singapore. "It's easier to see Japanese policy as an attempt at dissuading the yen from getting stronger than it is to driving the world's cheapest currency to ever cheaper levels."

The yen is unlikely to weaken past 124 per dollar in the next six months, he said.

Currency markets around the world are challenging the view that a looser monetary policy equals a weaker foreign-exchange rate, and because of that, they're complicating the outlook for central bankers who prefer a lower currency to boost inflation and economic growth.

Europe has struggled to translate monetary easing into exchange-rate weakness and inflation pressure, with the euro 4.6 per cent higher against the dollar since Dec 2, even though officials boosted stimulus the following day. While negative rates have helped the Swiss franc retrace some of its surge against the euro since the central bank stopped capping the currency's gains, it's still about 7 per cent stronger than the previous limit.

INVESTMENT FLOWS

Investment flows are supporting the yen, with the nation's government-run pension fund - the world's largest state investor - approaching its target overseas allocation.

About 22 per cent of the manager's US$1.1 trillion is already invested in international equities, with another 14 percent in international bonds. That's close to the respective targets of 25 per cent and 15 per cent, minimizing the amount of capital still destined to be sent overseas.

Commonwealth Bank said its clients should bet the yen will strengthen as Japan's growing current-account surplus, or the surfeit in the broadest measure of trade, is likely to outweigh the impact of stimulus.

"The yen will return to its pre-BOJ levels against the dollar," said Joseph Capurso, a currency strategist at Commonwealth Bank of Australia in Sydney. The yen will probably end the year at 112, he said.

Investors are also buying options that benefit from yen strength. The premium on contracts betting the currency will rise versus the dollar in three months, versus the cost of those to sell, was at 1.71 percentage points on Wednesday, close to 1.91 reached on Jan 20, the most since August 2011, data compiled by Bloomberg show.

Negative interest rates will slow the yen's appreciation, but not reverse it, according to Minori Uchida, head of global markets research at Bank of Tokyo-Mitsubishi UFJ Ltd., who sees currency potentially strengthening to 112 per dollar by year-end.

"Without the BOJ's negative rate, it could have gone to as high as 110 or 109 per dollar," Uchida said. "It is dangerous to underestimate the BOJ's negative rate policy too much, but as far as the overall direction is concerned there is no change in our view that the yen is on a strengthening path."

BLOOMBERG