• The USD/JPY appreciated by 5.4% in 1Q2018, largely on higher risk aversion. It ended 1Q2018 at 106.28 which is slightly stronger than our projection for the quarter of 113.

• Our long-term outlook on the USD/JPY suggests that the currency should exhibit an appreciating trend until 2020, supported by macro fundamentals added with a weakening USD cycle that should hit the bottom by 2024.

• We expect the USD/JPY to be on a slight weakening mode for 2018 to around 108 – 110 and possibly reach the 112 levels. Though our base case for 2018 suggests a weaker JPY against the USD, we can expect the JPY to strengthen during the year in view of its safe haven status or a growing perception that the BoJ may be nearing the start of its policy normalization, which is more likely to happen in 2019.

• Against the Malaysian ringgit (MYR), we expect the yen’s trend to be range-bound. We believe it is due to the initial cycle of a monetary tightening exhibited by the BoJ with its normalization to kick in in 2019. In the case of Malaysia, the monetary tightening is approaching a mature stage with the policy rate envisaged to normalize at 3.50%, providing another 25bps upside.

• In 2019, we expect the USD/JPY to shift from a weakening mode to a strengthening mode as we foresee the BoJ to likely end its current lose policy which has been helping to stimulate the economy through better economic conditions. We project the USD/JPY to hover around 108 – 111 and may go as strong as 105 in 2019. We foresee a switch in the yen’s momentum for 3Q2019 and to reach the 110 levels end-September before settling at 108 end-December. However, with the US bond yields rising rather than falling partly due to a tighter monetary policy, it reduces the need for the USD to depreciate.

A. USD/JPY stronger in 1Q2018

• Exciting month for JPY in January: The Japanese yen (JPY) strengthened 3.1% to 109.2 against the USD with its monthly average of 110.9. For the month, the pair traded between 108.6 and 113.1. The yen’s rise was underpinned by: (1) a general weakness in the USD; and (2) the Bank of Japan (BoJ) holding its short-term policy rate at -0.1% while expressing optimism on inflation outlook for 2018 and 2019 without implying a change in its easy monetary policy stance in January.

• JPY supported by safe haven status: The month saw significant volatility in global equity markets triggered by an inflation scare in the US, following the UST 10-year bond yield spiking to a record high of 2.95% on 21 February when the markets priced in for a four-rate hike by the US Fed in 2018 as opposed to three (3) after the release of strong wage growth data of 2.8% y/y in January. This saw investors flocking to safe haven assets that resulted in the JPY appreciating further by 2.3% to 106.68 against the USD. It traded between 106.1 and110.2, with a monthly average of 107.9.

• Stronger JPY in March: Volatility returned to global markets in March arising from Trump’s protectionist measures, specifically targeted at its bilateral trade relationship with China, which adversely affected overall sentiments. As a safe haven, the yen made further gains on higher risk aversion generally of 0.4% to 106.3. The pair traded between a range of 104.7 and 106.9 with a monthly average of 106.1.

• Overall, the yen appreciated by 5.4% in 1Q2018, largely due to higher risk aversion. It ended 1Q2018 at 106.3 which is stronger than our projection for the quarter of 113.

B. Long-term outlook on USD/JPY & DXY

• We investigated the USD/JPY outlook to establish the currency cycle. We found the pair exhibits a shorter cycle compared to the euro, pound and ringgit against the USD. In the case of yen, we found the weakening cycle against the USD to last for two years with an average fall of 5.9%. The appreciation cycle lasted for 3 years with an average gain of 8.5%.

• Given that the JPY has started to present a gaining momentum against the USD since 2017, we expect the appreciation momentum to last until 2020 when the currency hits the trough apart from being supported by a weaker USD long-term momentum (See Chart 1).

• We examined the Dollar Index (DXY) which measures the dollar against a basket of trade-weighted currencies with one of the main contributor being the yen. From our analysis, the DXY experienced a 7-year downcycle with an average fall of 7.8% while the upcycle was close to 9 years with an average gain of 6.6%. Thus, the DXY is expected to be on a weakening trend until 2024 (See Chart 2).

C. USD/JPY to gain momentum in 2019

• We recognise that JPY is undervalued against the USD based on fundamentals and is due for a reversion to “fair value”. Key to a JPY appreciation will be an upward momentum of the global economy which is likely to continue bringing higher growth, spending, and inflation.

• A pickup in inflation will lead the BoJ to end its extraordinary monetary policies which were put in place to fight deflation and raise interest rates to deal with the new more inflationary environment. Higher interest rates strengthen the JPY as they attract foreign money to the shores with the promise of higher returns. Also, it may also stop the outflow of money into higher yielding foreign investments which have been the bane of the deflationary years, and a constant undermining factor for the yen.? Our base case for USD/JPY is that the pair exhibits a slight weakening mode for 2018, projected to hover around 108 – 110, with the room to reach the 112 levels. In our projection, we foresee the USD/JPY gaining from 106.3 end-March to our projection of 108 end-June and reach 109 end-September before settling at 110 end-December.

• In 2019, we expect the USD/JPY to shift from a range-bound mode to a strengthening mode. We foresee the BoJ ending the current lose policy which has helped stimulate the economy through better economic conditions. We project the currency would hover around 108 – 111 and could go as strong as 105 in 2019. We believe the USD/JPY will reach 111 end-March and 112 end-June. We foresee a switch in the yen’s momentum for 3Q2019 and to reach the 110 levels endSeptember before settling at 108 end-December.

• Key drivers of USD/JPY are:

1. The economy has grown for eight straight quarters, its longest continuous expansion since the 1980s bubble economy, moving a step closer to vanquishing decades of stagnation. Consumer spending, capital expenditure and exports have helped drive growth. We project the GDP to grow 1.5% in FY2018 and 1.1% in FY2019 from 1.7% in FY2017.

2. We expect a modest increase in inflation amid tightening labour markets. Inflation should hover around 1.0% in 2018 and 1.5% in 2019. Thus, we foresee the current ultra-loose monetary policy whereby the short-term interest rates is pegged at -0.1% and the 10-year government bond yield around zero percent will continue. This should keep the JPY at a weaker level.

3. For now, a key challenge is that private consumption could be subdued if wage and income growth remains modest. A slow growth in wages poses a challenge to policymakers trying to inject further momentum into an economy now in its best run of expansion in 28 years. Higher pay increases would support the Bank of Japan’s 2% inflation target. Hence, we expect the JPY to exhibit some level of weaknesses.

4. Our other worry is on the potential threat of US trade protectionism. Trade friction could bring about a heavy blow to exporters who have benefited from solid global demand. Japan’s swelling current account surplus above 2 trillion yen is good for its finances but may not be so for its relationship with the US since it becomes an easier target of attacks from the US. Trade surplus with the US is around 631 billion yen, up 3.4% y/y as of February 2018.

5. Also, with the economy growing and inflation slowly but steadily rising, possibilities for the BoJ to begin normalizing its ultra-loose monetary policy cannot be ruled out. In our opinion, it is more likely to happen in 2H2019.

6. So, the risk for the JPY to strengthen against the USD as we go forward cannot be ruled out in view of its safe haven status or growing perception that the BoJ might be nearing the start of its policy normalization, which is likely to happen in 2019. A strong yen could deal a heavy blow to the exporters who have benefited from solid global demand and put a lid on the upside for inflation.

• Against the Malaysian ringgit (MYR), we expect the yen’s trend to be range-bound. It could be due to the initial cycle of monetary tightening exhibited by the BoJ with its normalization to kick start in 2019. As for Malaysia, the monetary tightening is approaching a mature stage with the policy rate envisaged to normalize at 3.50%, providing another 25bps upside.

• While we project a weakening USD/JPY in 2018 based on the fundamental factors, we cannot rule out on the possibilities for the JPY to appreciate against the USD in view of negative noises given its safe haven status. However, we envisage the US bond yields rising rather than falling partly due to a tightening monetary policy, which offsets some of the need for the USD to depreciate.

Source: AmInvest Research - 13 Apr 2018