'Go Big Or Fail' for Japan; USD/JPY rally a selling opportunity
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Morgan Stanley says to fade the USD/JPY rally
Bernanke to the rescue: Once again, the topic of expectations has become crucial for the performance of markets at least. Yesterday, JPY saw its biggest one-day decline since 2014 on expectations that the Abe coalition government would launch a 'bold' fiscal package. The market is now priced for more than JPY10trn, but it will be more about the fiscal-monetary coordination that is driving markets, especially local equities and JPY, over the next few days and weeks . The previous Fed Chairman Bernanke, who initiated QE3, is visiting the BoJ, inflating markets with expectations that the BoJ is accompanying the fiscal stimulus with ultra-loose policies, taking Japan closer to what is widely known as providing helicopter money.
Japan's challenge: The low and flat JPY yield curve is a threat to Japan's financial sector. For Japan to look better it requires higher inflation expectations to steepen the yield curve, helping local banks and insurance companies. Keeping bond yields low for longer undermines Japan's financial institutions further, reduces monetary velocity and pushes JPY higher. Hence, Japan maintaining its traditional policy path is not an option, in our view. The effectiveness of fiscal expansion declines with the increasing debt burden, as proven by Rogoff and Reinhart. Consequently, Japan with its record debt levels should not count on fiscal policy alone to provide much of an economic tailwind. It may need the assistance of a 'shock and awe' monetary policy step together with the fiscal package to be able to boost long-term inflation expectations.
Go big or fail: Past experience showed that conventional QE did not do the trick. What may change matters is the BoJ leaves the impression of funding fiscal policy beyond the life span of a generation. In this case, Japan's households and corporates would not regard today's fiscal spending as tomorrow's tax bill. It has been Japan's high private sector savings pushing Japan's current account back into surplus and reducing local price expectations. It needs to be seen if Japan is able to develop more radical measures compared to the past to trigger necessary shifts of inflation expectations strong enough to steepen the JGB curve and to undermine JPY. We doubt that and view USDJPY rallies as providing selling opportunities.
*Morgan Stanley hit profit-stop today on its USD/JPY short from 106 around 103.60.
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