• Calls for a Yen sell-off have been an ongoing feature of the economic Kommentariat for the past three years. They have gained renewed vigor as the BoJ engages in yet another round of quantitative easing against a backdrop of a relapse into recession, persistent deflation and a deterioration in Japan’s trade performance.
• Yet, a sharp depreciation is unlikely, in particular against the USD. The BoJ lags other central banks significantly in the aggressiveness of its monetary operations, the Fed is likely to be further emboldened by the unavoidability of some degree of ‘fiscal cliff’, Japan’s worsening trade performance is dwarfed by the size of incoming capital flows and risk aversion is set to keep JPY bid.
• This is not to say that there are not good reasons for the Yen to weaken in the medium term: demographic change and a declining savings rate represent powerful headwinds in the medium term. So does the potential of more radical steps by the BoJ. But neither are imminent and a sharp move beyond 80 thus remains unlikely for now.

In an environment of near-record low volatility in FX markets and a broad convergence of G7 interest rates to the zero-bound, investors seem transfixed by the actions of the Bank of Japan (BoJ) and the promise of sustained Yen depreciation. Successive rounds of asset purchases against a backdrop of a relapse into recession, persistent deflation and a deterioration in Japan’s traditionally strong trade balance have made markets believe time and again that the Yen was poised for a sell-off (see chart). Not least, this also reflects a commonly held view that the Yen serves as a safe haven destination for foreign capital and that it’s attractiveness would wane as risk assets receive increased support from aggressive monetary easing globally.

The Yen indeed began to weaken since late July, by some 4.4% in effective terms. To a large extent this owed to the Euro rally though, which saw EURJPY appreciate some 9.8%. USDJPY has been more steady and only began to move upwards at end-September when it began its ascent to 80.30, a 3.5% move. There is some justification to the expectation that JPY could weaken in the wake of the BoJ’s latest actions as USDJPY  appears to be tracking the relative balance sheet size of the BoJ versus that of the Fed. Indeed, the pair seems to be lagging the change in the ratio, suggesting a likely upward move in USDJPY (see chart USDJPY & Central Bank Balance Sheets).

Nevertheless, several arguments undermine the case for ongoing Yen depreciation, in particular against the USD:

1. Slowdown averted, no acceleration: The decision by the BoJ to increase its Asset Purchase Program did not accelerate the pace of planned purchases for the remainder of this year. Instead, it simply promises not to slow it as much as envisaged in the previous plan (a JPY13 trn increase in both 2013 and 2014 rather than the JPY10 trn and JPY5 trn respectively planned before).
2. Fed action yet to be felt: The Fed’s balance sheet has remained broadly stable at $2.8-2.9 trn since mid-2011. The commitment to open-ended purchases of MBS at a $40 bn monthly clip has yet to make itself felt in the balance sheet (and may take longer given the settlement modalities of these securities), implying that the trend in the ratio of the two central bank balance sheets is likely to reverse.
3. ‘Fiscal Cliff’ could spur Fed further on: However, this commitment is not really “open-ended” as the Fed’s ability to hover up MBS is limited. If it proceeds at the planned pace for a year, adding roughly half a trillion dollars worth to its assets by end-2013, it will own some ¾ of that market, all else equal. But in the face of the looming fiscal cliff, which is unlikely to be defused completely in the wake of an broadly unchanged House/Senate composition, the Fed could yet adopt more aggressive measures, not only adding to its UST holdings but even purchasing equities and/or other assets.
4. Scaling the BoJ balance sheet: The size of the BoJ’s balance sheet relative to its economy is in line with that of the ECB at just over a third of GDP, larger than the position of the Fed or the BoE but dwarfed by that of the SNB. However, this owes much to the legacy of a decade-long policy of quantitative easing. Relative to where it started the crisis, the BoJ increased its balance sheet by merely a third, compared to the tripling or quintupling of their balance sheets other central banks have engaged in (see chart Central Bank Balance Sheets, normalized to Jan 07 = 100).
5. Risk aversion to support JPY: Finally, in a world where tail risks abound – from a re-escalation of the EZ crisis to a Chinese economic slowdown-cum-leadership crisis to a failure to defuse the US fiscal cliff and a relapse into recession – the demand for safe haven currencies will likely remain unimpinged. This will also benefit the USD but if the primary locus of risk is now in the US (and implies reinforced Fed action), USDJPY will likely remain weighed down.
6. BoP is what matters, not just the current account: Much ado has been made of the deterioration of Japan’s traditionally strong external balance. This reflects a combination of factors, some temporary, others perhaps more permanent: an increase in energy imports due to the disruption/end of nuclear power production, a Chinese boycott of Japanese imports in the wake of the Senkaku dispute, a lack of demand in key G10 export markets and the effects of Yen strength on Japanese exports. But it is important to consider the entire balance of payments, not just the current account as the size of financial flows dwarfs trade-related ones. In particular, Japanese households hold the key to directional Yen moves (especially in the post-leveraged/carry world) and their decisions are largely determined by the performance of the domestic economy. As such, it is not surprising that foreign currency investments via ”Toushin” investment trusts remain in the doldrums, at 41% off their previous peak (see chart Foreign currency assets of publicly offered investment trusts, JPY 100 bn).
7. JPY valuation not extreme: Thanks to years of deflation, valuation metrics for the Yen are not at extreme levels yet. For example, in real effective terms, the Yen is only at some 70% of its 1995 peak. In other words, USDJPY would have to reach 53 in order to reach that same level, all else equal. Meanwhile, official FX intervention by the MoF has proved ineffectual time and again.

All of this is not to say that there are not powerful reasons to expect a weaker Yen in the medium term. Japan’s population is ageing rapidly, a powerful negative for its exchange rate. The share of over-65 yr olds is projected to pass from 17% in 2000 to 36% in 2050 (it was 5% in 1950). As the total population shrinks as well, this will reduce the  economy’s productive capacity and shift its composition to a greater reliance on consumption, to the detriment of export generation. An erosion of the propensity to save – already down from 20% of disposable income in the 1980s to 0% – will mean that the traditionally large income surplus will also dwindle. However, with the legacy stock of private domestic savings high, eroding it will be a long-winded process.

Nearer in time, a decision by the BoJ to engage in more aggressive stimulus measures – perhaps due to a further intensification of political pressure – could yet see the Yen slide. But this would require more radical steps, such as the purchase of foreign bonds (directly affecting the exchange rate) or a price level target, to have an impact. As of yet, there is no sign that the BoJ is contemplating such a move.

An unsettled global environment, characterized by widespread and more aggressive monetary easing elsewhere than in Japan, will likely keep the Yen supported. Announcements of its imminent demise remain premature.