The yen remains on an appreciating trend but with recent strength taking the currency into overbought and overvalued territory, the BoJ is unlikely to allow the currency to appreciate much further, and we hold a neutral near term view. The combination of weak growth and high inflation relative to the US should drive medium-term weakness, in spite of the country's huge external asset position.
Despite the strong Q116 real GDP growth figure, Japan's economy is unlikely to mount a sustainable recovery as the current policy mix continues to undermine productivity. The BoJ will continue to ease, likely cutting interest rates deeper into negative territory at its upcoming meeting, while fiscal stimulus spending will remain elevated, both to the detriment of private investment.
The Japanese government's decision to delay its proposed sales tax hike until late-2019 shows the lack of willingness by policymakers to take necessary but painful steps to rectify the country's fiscal imbalances. This, combined with the high likelihood of additional fiscal stimulus measures, will fail to support economic growth, increase government bond issuance, and necessitate a further expansion of quantitative easing. These developments will in turn give rise to growing inflationary pressures and a weaker Japanese yen over the medium term.
The recent rise in the yen has seen inflation expectations fall markedly. However, we continue to see medium term inflation pressures rising as the BoJ is forced to further expand its easing measures, leading to an acceleration in money supply growth, which is already growing at a solid pace.
The ruling Liberal Democratic Party-Komeito coalition looks set to perform solidly in the July 10 upper house elections, despite growing criticisms of the government. A clear coalition victory would reignite Prime Minister Shinzo Abe's 'Abenomics' reform programme, although Abe's advocacy of constitutional reform will remain highly divisive over the medium term.
Major Forecast Changes
We have revised our forecast for the Japanese yen stronger following the surge seen in the first half of 2016. However, we believe that this strength could ultimately cause the BoJ to redouble its efforts at generating long term inflation, and thus we maintain our bearish long term view on the currency.
The major risk to the Japanese economy comes from the potential for the Bank of Japan to step in to prevent further yen strength by rapidly increasing some form of money printing. This could come in the form of greater equity ETF purchase, deeper cuts to interest rates, or applying negative rates on certain loans to the banking system. This could trigger a sharp jump in inflation expectations as Japanese citizens may be less inclined to hold yen, particularly given the ongoing increase in the money supply.
The largest upside risk comes from the potential for Shinzo Abe to push through more structural reforms in the event that the LDP-led coalition gains a strong mandate in the upcoming upper house elections.
|Real GDP growth, % y-o-y||0.0||0.4||0.6||0.5|
|Nominal GDP, USDbn||4,599.1||4,122.1||4,707.8||4,900.4|
|Consumer price inflation, % y-o-y, eop||2.4||0.2||1.0||2.2|
|Exchange rate JPY/USD, eop||119.80||120.20||102.00||106.00|
|Budget balance, % of GDP||-7.9||-7.8||-7.1||-7.2|
|Current account balance, % of GDP||0.5||3.3||2.7||2.4|
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