A weaker yen has been instrumental at drawing Japan out of protracted deflation.
The Bank of Japan has run the world’s most aggressive monetary policy.
Now that inflation is recovering gradually, the BoJ could change tack – a positive for the yen.
Market turmoil could once again support the currency, which remains viewed as a safe haven.
When Shinzo Abe regained power in 2012, he decided to fight deflation through flexible fiscal policy, structural reforms and aggressive monetary easing. This approach – better known as Abenomics – has helped Japan record its longest streak of positive growth in 30 years and put inflation back on the rise.
While price pressure remains moderate, the government has managed to secure a 2.3% increase in wages from employers in 2018. With growth now running at twice its potential and unemployment at a 30-year low, inflation could rise further. And now that deflation is a more remote risk, the Bank of Japan (BoJ) could remove support gradually, driving the yen up – the currency remains undervalued by around 29% according to OECD estimates.
Although the correlation has loosened lately, a soft yen has helped the export-driven economy move out of deflation – exports account for 33% of top-line sales of TOPIX firms and are concentrated in a handful of sectors (automobile, industrials and technology). A return to positive growth and inflation could now trigger a pick-up in domestic earnings, which account for the bulk of Japanese profits.
Market turmoil could also benefit the yen as it remains considered as a safe haven. In times of turbulence, investors unwind their carry trade positions funded in yens, and domestic investors repatriate overseas assets. With a bumpier 2018 on the cards, the yen may gain ground as risk aversion returns.
All in all, we see upside for the yen this year and – if the above JPY-positive factors all combine – an overshooting is a distinct possibility.