[LFX]

There are four reasons for the JPY strength: First, Japanese banks are buying domestic securities at an increasing pace while foreign bank claims are still falling, suggesting that Japanese banks will try to make money by investing at home instead of lending abroad. Secondly, there are now five currencies offering near zero funding rates suggesting the global liability-book is being reallocated out of JPY with borrowres using other currencies for funding purposes. Third, the MOF/BOJ are moving away from an interventionist approach, effectively withdrawing the ‘USDJPY put’. Fourth, the incoming Japanese government is pushing domestic demand as it no longer believes in Japan’s export model.

Japan has created surpluses for decades and over recent years the private sector has become increasingly important for recycling these surpluses. Bond market holdings have been Japan’s preferred non-JPY asset class. There are two factors driving the JPY when analysing the impact of changes to Japan based on investors foreign bond portfolio. First, the yield differential which is declining and secondly the slope of the foreign yield curve. The yield differential determines the incentive to invest abroad, while the yield curve determines the currency hedging ratio for these investments.

Examine the relationship between EURJPY and the slope of the yield curve. Since February, the euro has performed better than suggested by the euro yield curve. Analysts attribute the better performance to investors using the euro as the anti-USD. From February until May the USD had built up a risk premium as the FED conducted an aggressive quantitative easing strategy. Now US bond yields are declining as official accounts move back into the US yield curve, suggesting that the USD risk premium is declining. The simultaneous decline of official accounts liquidity holdings with the FED tells the FX market that the risk of central banks reallocating funds away from the USD into the EUR has been reduced, putting the Euro under pressure. Hence, the relationship between the yield curve and EURJPY should fall back into force suggesting EURJPY will decline.

Meanwhile, equity markets have started correcting lower. The Shanghai index has lost 50% of its advance seen since October 2008. Commodities will soon follow the Shanghai index as both markets have been fed by the some source of liquidity, namely Chinese credit. Commodities often represent the asset side of JPY funded carry trades. Pointing in the same direction is the EMK weakness with the currencies that set the starting point for the rally in spring, such as the CLP and BRL, now moving lower. As far as we can judge we see risk appetite in retreat and as this happens it will move EURJPY away from current overvalued levels.