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Takeaway: The case for incremental monetary easing amid fiscal tightening (via the consumption tax hike) grows louder in Japan.

SUMMARY BULLETS:

  • On both a QoQ SAAR and YoY basis, the most recently reported economic growth deltas were extremely low quality in nature as the government continues to be largely the only game in town as it relates to economic activity in Japan.
  • In the context of Japan’s private sector growth being too weak to orchestrate a smooth handoff from the government, we believe the BoJ may be forced to accelerate its balance sheet expansion over the intermediate term – especially if the consumption tax is going to be hiked as currently outlined in Japanese fiscal policy.
  • It should be noted that quantitative setup on the dollar-yen cross (i.e. Bearish TREND) is only a few days young and needs to hold below TREND for a few weeks to confirm the move. If, however, the move is subsequently confirmed, we would certainly alter our fundamental bias to a stance that is a more neutral on the Japanese yen, or perhaps even outright bullish if the US and Japanese growth data supports that conclusion.
  • If implemented, this fundamental shift would likely provide us with a ripe opportunity to short Japanese equities for the first time in a long time; the Nikkei is up +59.3% from its TTM low and the trailing 1Y and 3Y correlation coefficients between the USD/JPY spot rate and the Nikkei 225 Index are +0.96 and +0.97, respectively.
  • For now, however, we are inclined to maintain our negative bias on the Japanese yen (TREND and TAIL durations) and our positive bias on Japan’s equity market (TREND duration). The aforementioned scenario analysis is just our way of thinking out loud as we patiently wait and watch for confirming or disconfirming signals.

On balance, Japan’s 2Q13 GDP report was not good. Real GDP slowed to +2.6% QoQ SAAR from +3.8% in 1Q13 [revised down from +4.1%]. That headline figure was 100bps shy of the Bloomberg consensus estimate of +3.6%.

On a YoY basis, Japanese real GDP growth did accelerate to +0.9% from +0.3% prior, but, much like the headline QoQ SAAR figures, the YoY growth deltas were extremely low quality in nature as the government continues to be largely the only game in town as it relates to economic activity in Japan.

QoQ SAAR deltas:

  • C: +3.1% from +3.4% prior
  • I: -0.4% from -0.7% prior
  • G: +3.4% from +0.2% prior
  • Exports: +12.5% from +16.8% prior
  • Imports: +6.2% from +4.1% prior
  • Private Demand: +1% from +2.5% prior
  • Public Demand: +4.2% from +1% prior

YoY deltas:

  • C: +0.9% from +0.3% prior
  • I: -4.7% from -5.1% prior
  • G: +1.9% from +1.1% prior
  • Exports: -0.3% from -3.3% prior
  • Imports: +0.8% from +0.4% prior
  • Private Demand: +0.3% from -0.1% prior
  • Public Demand: +3.3% from +3.5% prior

JAPAN’S WEAK ECONOMY + CONSUMPTION TAX HIKE = BOJ EASING… OR ELSE - 1

 

JAPAN’S WEAK ECONOMY + CONSUMPTION TAX HIKE = BOJ EASING… OR ELSE - 2

It could be argued that the lone “bright spot” from this morning’s data release was that the GDP deflator accelerated to -0.3% YoY from -1.1% prior; that was the fastest reading since 3Q09. Indeed, Japanese policymakers are starting to get their first whiffs of the inflation they so desperately seek, but it remains well shy of their +2% target.

In the context of Japan’s private sector growth being too weak to orchestrate a smooth handoff from the government, we believe the BoJ may be forced to accelerate its balance sheet expansion over the intermediate term – especially if the consumption tax is going to be hiked as currently outlined in Japanese fiscal policy.

Recall that a pretty severe recession followed the last time Japan hiked its consumption tax back in 1997; the move cost then-prime minster Ryutaro Hashimoto his post and ultimately forced the BoJ to ease monetary policy. The USD/JPY gained 36 handles from JUN ’97 to SEP ’98 when a globally-coordinated intervention stopped the yen from crashing.

JAPAN’S WEAK ECONOMY + CONSUMPTION TAX HIKE = BOJ EASING… OR ELSE - 3

For now, all signs on that front support a status quo outcome (we’ll know for sure in late SEP/early OCT when the Cabinet Office makes its “final decision” post the final revisions to this morning’s GDP report); Finance Minister Taro Aso, Economy Minister Akira Amari and BoJ Governor Haruhiko Kuroda – all of whom will be on Prime Minster Shinzo Abe’s tax hike panel – are in favor of the move.

It is our view that, if the Cabinet Office proceeds as planned with respect to the consumption tax hike, the BoJ is likely to accelerate its balance sheet expansion to help make sure the economy doesn’t lose any momentum on the growth and inflation fronts. That, on the margin, would be bearish for the Japanese yen.

To review our negative bias on the Japanese yen (TREND and TAIL durations) and our positive bias on Japan’s equity market (TREND duration):

  1. While enthusiasm for the Abenomics agenda may come and go in the immediate-term, we believe investors are broadly underestimating the structural impact of imposing a +2% inflation target and +3% nominal growth target in Japan. To put that in context, the trailing 10Y averages for these metrics are -0.1% and -0.5%, respectively. Japanese policymakers have a lot of hay to bale on the monetary easing front if they are to even sniff their lofty targets within the proposed 2Y time frame.
  2. Assuming Japanese policy stays the course and our view that the US economy has finally turned the corner from a growth perspective is ultimately proven prescient, a compressing real interest rate differential will also put pressure on Japan’s currency from a capital flows perspective. Consensus expects real 2Y JGB rates to hit -2.5% by EOY 2014 (down meaningfully from -0.4% by EOY 2013); this compares to a forecast of -1.3% for real UST 2Y rates by EOY 2014 (down slightly from -1.1% by EOY 2013). More importantly, this inflection is also being confirmed in the swaps market: 2Y swap rates in Japan are now trading at -1.57% on a real basis (subtracting the 2Y breakeven rate from the swap rate); that compares to -0.88% for the US. As recently as mid-MAR, those metrics were meaningfully inverted at -0.10% and -1.98%, respectively!
  3. In the context of intermittent spikes in volatility in the bond and forex markets, we have maintained that the risk-adjusted outlook for Japanese stocks is decidedly less sanguine than consensus assumes given the reflationary tailwind of currency debasement. The caveat here is that this headwind can be offset via absolute returns that are now likely to be increasingly predicated on economic and fiscal reforms (corporate tax cuts, labor market deregulation, fiscal consolidation, etc.), as well as large-scale portfolio rebalancing by Japanese households. To that tune, only 6.8% of Japanese household financial assets are held in equities vs. 14.4% for the Eurozone and 32.8% for the US.

In spite of what we’ve outlined as arguably the most credible and well-articulated bull case for both the USD/JPY cross and Japanese equities, both are broken from an immediate-term TRADE perspective and flirting with breakdowns on our intermediate-term TREND duration as well. The risk management levels to watch on that front are as follows:

  • USD/JPY (last price = 96.55): Bearish TRADE = 97.72 and Bearish TREND = 97.13
  • Nikkei 225 (last price = 13,519): Bearish TRADE = 14,091 and Bullish TREND = 13,336

JAPAN’S WEAK ECONOMY + CONSUMPTION TAX HIKE = BOJ EASING… OR ELSE - 4

 

JAPAN’S WEAK ECONOMY + CONSUMPTION TAX HIKE = BOJ EASING… OR ELSE - 5

It should be noted that quantitative setup on the dollar-yen cross is only a few days young and needs to hold below TREND for a few weeks to confirm the move. If, however, the move is subsequently confirmed, we would certainly alter our fundamental bias to a stance that is a more neutral, or perhaps even outright bullish if the US and Japanese growth data supports that conclusion.

If implemented, this fundamental shift would likely provide us with a ripe opportunity to short Japanese equities for the first time in a long time; the Nikkei is up +59.3% from its TTM low and the trailing 1Y and 3Y correlation coefficients between the USD/JPY spot rate and the Nikkei 225 Index are +0.96 and +0.97, respectively.

Patience should pay dividends for those inclined to wait and watch here.

Darius Dale

Senior Analyst