Japan, Abe, and the Yen

The yen was sidelined this week and support for Abe’s cabinet has declined by 10% – what is next for Japan?

The yen has been sidelined this week. It is flat against the dollar. Japanese stocks and bonds are also little changed. The benchmark 10-year bond yield has fallen by less than two bp on the week, the least among the major bond markets.

The Nikkei is off 0.3% on the week, which is the second best performance in the G7 behind Italy’s 0.2% rise. Although the BOJ equity buying is focused on the large-cap stocks, the smaller cap stocks continue to outperform. This week the JASDAQ and TSE Mothers Index rose 0.7% and 0.9% respectively.

We had noted that Prime Minister Abe spent some of his political capital to push through controversial reforms that permit a larger international role for Japan’s Self-Defense Forces. It is these issues that fire Abe’s passion, but the economy had to be addressed first. It is not clear that the economy has turned the corner though officials say it has. While China and Europe reported disappointing flash PMIs, Japan’s preliminary PMI rose to 51.4 from 50.1, which was also well above market expectations, there is some concern that the Japanese economy stagnated in Q2 or worse.

Support for Abe’s cabinet has fallen 10 percentage points to 37.7% over the past month. The military agenda and the spending overruns on the new national stadium (for the 2020 Olympics) have undermined support. However, there are three events on the near-term horizon that may bolster Abe’s support. First, next month Abe is expected to deliver a big visionary speech commemorating the end of WWII. Second, the first nuclear plant is expected to come back online since they were all shut following the earthquake, tsunami and nuclear accident in 2011. Third, Abe may visit China in September and a meeting with President Xi.

It is not clear how much Abe’s speech can rebuild confidence in the government. The restarting of the nuclear plant is also controversial. Moreover, given China’s criticism of Abe and his nationalistic policies, the meeting with President Xi could be canceled. Nevertheless, as long as the cabinet’s support remains above 30%, the pressure is likely to be modest. A loss of 20% is seen as more serious and a potential threat to Abe’s tenure. Abe is also fortunate that there are no compelling rivals either within the LDP or opposition parties. If there are no major programmatic differences, it is difficult for a challenger to arise.

Meanwhile, more economic work needs to be done. As Abe shifts his focus to his political agenda, the IMF calls on renewing his economic agenda. The IMF warned yesterday that unless additional fiscal measures are introduced, Japan’s debt-to-GDP may rise toward 300% over the next 15 years. It is critical of Japan’s reliance on optimistic economic assumptions to achieve a primary budget surplus by 2020. Fitch expressed similar concerns when it downgraded Japan’s credit rating in April. The IMF also warned that the BOJ may have to provide more stimulus if it is going to achieve its inflation target in the medium-term.

The IMF noted that when adjusted for inflation and trade, the yen is “moderately” below long-term equilibrium. By the OECD’s measure of purchasing power parity the yen is about 17.7% below fair value, second among the majors to the euro (-17.8%). This is the “cheapest” the yen has been according to the OECD since at least 1985. In 2011, the OECD estimated the yen was 30% over-valued.

Japan’s economic data releases are often concentrated at the end of the month. Next week brings retail sales, industrial output, employment, household spending and CPI. The data is expected to be broadly mixed, with softness in retail sales (after a 1.9% rise in May) and better industrial production (after a 2.1% decline in May). The employment report is expected to be little changed.

The most important reports are the household spending and inflation. Both are likely to have slowed sequentially. Spending is expected to have slowed to a 1.9% year-over-year pace from 4.8% in May. The Bloomberg consensus expects headline and core (which excludes fresh food but includes energy) to have slipped by 0.1% for the nation in June and for Tokyo in July. If so, the year-over-year core rate for Japan and Tokyo would be zero. The more recent decline in oil prices (and other commodities) will do the BOJ’s effort to lift inflation no favors.

The dollar has been confined to about a 3/4 yen range this week between JPY123.75 and JPY124.50. Three-month implied yen volatility neared the lows for the year earlier this week before ticking higher in the second half of the week. Even though the dollar looks at risk against the yen given the pullback in stocks and US bond yields, short-term participants are unlikely to want to get too short ahead of the FOMC meeting next week and the following week’s US jobs report. Over the medium and longer terms, dollar pullbacks will likely be seen as better buying opportunities for investors.