Will a Weak Yen Push the BoJ into Action?

July 3, 2022

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The Japanese Yen was hammered by markets in the second quarter. USD/JPY shot by the 2002 peak, touching its highest since 1998. A key driver of the Yen’s weak point has been the Bank of Japan’s coverage divergence from its main friends. While central banks like the Fed and RBA gave shock hikes, the BoJ remained persistently dovish, making life troublesome for its forex. On the chart under, USD/JPY could be seen rising as US Treasury yields outpaced their Japanese equal. Could this alteration forward?

Japanese Yen Fundamental Drivers

Chart Created Using TradingView

Rising Inflationary Forces

A key cause why the BoJ reaffirmed its ultra-loose coverage is low Japanese inflation. This has been slowly altering. Local CPI was 2.5% y/y in May, above the central financial institution’s 2% goal. The BoJ has traditionally struggled to carry inflation in goal. Some of that is possible as a consequence of causes exterior of its management, equivalent to demographics. But even Japan is beginning to really feel the pinch of rising costs. The island-nation economic system is the world’s 4th largest shopper of oil, which has turn into dearer.

In the second-quarter Yen outlook, I attempted to foretell Japanese inflation primarily based on crude oil and coal, additionally factoring in time. By eradicating the lag from CPI information, I may use latest power value information to estimate the place Japanese inflation may go in the coming months. The strategy accurately estimated inflation breaching the Bank of Japan’s 2% goal in Q2. In this text, I revisited the authentic a number of linear regression mannequin and simplified it by taking out the affect of coal. I then constructed a second mannequin that tries to think about the Yen’s devaluation. But extra on the latter shortly.

The first mannequin under has an R-squared rating of 41%. In different phrases, solely 41% of the variation in Japanese CPI is defined by crude oil and time. More to the level, it vastly underestimated the precise CPI in May (0.97% y/y anticipated versus 2.5% printed).

Estimating Japanese CPI – Model 1

Source: Bloomberg, Chart Prepared by Daniel Dubrovsky

Will a Weak Yen Translate into BoJ Action?

The second mannequin under tries to foretell Japanese CPI by additionally factoring in the Japanese Yen and holding fixed G20 CPI. This is to see if a devalued forex could possibly be an inflationary pressure for the island-nation economic system. This mannequin has a greater R-squared at 60%, that means that 60% of the variation in Japanese CPI is defined by the variables. The greater accuracy of the mannequin suggests the Yen could possibly be a key think about driving inflation. Without the Yen, the accuracy drops to 53%.

This mannequin nonetheless underestimated precise CPI in May (1.8% seen versus 2.5% printed). It does see a slowdown in early Q3 earlier than inflation rises again to focus on. It will stay to be seen if the BoJ will spring into motion. A basic rule of thumb for merchants is to not combat central banks. As such, a dovish BoJ ought to nonetheless work towards the Yen. But, a mixture of inflation close to goal and rising considerations about JPY’s stage may maybe assist stabilize the forex in the months forward.