EM Outflows, US monetary policy, Japan Earthquake, USDJPY levels

Since the US election day, EM markets have lost USD11bln of international capital as investors moved out of EM equities and bonds. Unsurprisingly, it has been Asia mostly hit by the outflow. A couple of reasons are worth mentioning. First, Asia received two thirds of all EM inflows seen earlier this year as investors piled into AxJ fixed income and then when local risk free rates fell, emphasised equity flows. Second, yield differentials have remained a nominal story so far which is essential for keeping risk appetite supported. As long as US real yields remain muted, investors will see little reason to reduce their valuation of risky assets. Yes, over the past couple of weeks there have been days when US real yields were rising, but this increase seems related to liquidation pressures rather than a fundamentally justified rise of US real yields. DM central bank rhetoric suggests that there is no appetite for higher real rates yet as investment spending has not reached levels to break away from what some call ‘secular stagnation’. US Fed Chair Yellen has suggested that her monetary policy decision making may involve allowing the US economy to run hot. In this environment there would be a pick up of investment spending. This approach requires real yields staying low implicitly, thus implicitly supporting risk appetite for now, keeping our FX trading interest in selling low yielding currencies.

It will be only much later in the cycle when DM central banks see better investment spending suggesting real yields moving higher. That is when the USD rally may change its focus from low yielding towards high yielding currencies. Overnight saw US breakeven yields rallying again supported by sharply higher commodity prices. US real yields may ease back somewhat from here, but due to the BoJ’s yield curve management, Japan’s real yield is now falling sharply. This morning’s JPY reaction to the 7.4 magnitude earthquake near the Fukushima coast line tells it all. After a brief USDJPY dip to 110.27 this currency pair recovered quickly now overcoming channel and cloud resistance stopping bearish moves around 111.00/36. A daily closing price above these levels suggests the rally may extend to its 115.10 February high.

Surprisingly, markets are still long the JPY not only manifested by IMM net commercial JPY long positions, but also BoJ’s large scale survey of the nation’s financial literacy explaining households have a high share of deposit holdings relative to total financial assets. Cash and deposit holdings are an expression of risk aversion. Japan may need a period of negative real yield to push investors into higher yielding assets. The consequently better allocation of capital may improve Japan’s productivity outlook. Now as the globe shows signs of reflation, impressively illustrated by sharply rising commodity prices, the BoJ has a chance to impose negative real yields which should push Japan’s cash holding households into higher yielding foreign and domestic asset holdings including its share market.


A pushback to our JPY bearishness often involves Japan’s 4% current account surplus. Arguments used are two fold. First, JPY weakness increasing the surplus further may trigger the US Treasury to impose trade sanctions. Secondly, the surplus itself creates commercial JPY demand limiting the JPY’s downside potential. Our view suggests that higher commodity prices plus Japan seeing its domestic demand and inflation outlook improving will reduce the current account surplus. A weaker JPY kick starting inflation expectations to rebound is one of the few tools left that Japan can use to improve its domestic demand outlook. In addition, JPY demand derived by the rising CA surplus may be easily outbalanced by JPY selling interest coming from Japan currency managing its substantial JPY331trn foreign asset position.