JPM Key factors for JPY view

JPM Key factors for JPY view

 We had initially forecasted a steeper negative turn in
market sentiment for 1Q 2012, which would have led
JPY-crosses much lower than current levels. However,
we may have underestimated the impact of the 3-year
LTRO on peripheral bond markets, where yields are
declining rapidly. If the next 3-year LTRO has the same
effect on peripheral debt markets, JPY-crosses are bound
to move higher, while USD/JPY could start declining
earlier than we had anticipated.

 Since the collapse of Lehman, JPY has shown a tendency
to be bought when stock prices fall, but not necessarily
sold when stocks rally. This is likely due to the fact that
JPY carry trades are not as popular as they were before,
largely since USD has become the more preferred
funding currency since its interest rate has declined to
near-zero levels much like JPY, while its fundamentals
(current account, external positions) are comparatively
weaker. This further strengthens the bias for a stronger
JPY against USD, which would be even more magnified
under the current risk rally.

 The proportion of JPY within global foreign reserves has
been increasing moderately to the highest level since 1Q
2005, although still well below levels seen in 2000.
Given that an increase in the proportion of JPY seems to
have had a positive effect on the performance of foreign
currency reserve portfolios in recent years, buying from
foreign reserve accounts are likely to be a supporting
factor for JPY as well.

 Any further JPY-selling intervention is likely to be
unilateral and one-off. US criticism on BoJ/MoF
intervention has made it even more politically difficult
for Japan to conduct massive and sustained intervention.

Bearish risks to the view
 Swift agreement of Greek PSI talks, as well as an
increase in lending capacity of EFSF/ESM as well as the
IMF

 Rising expectations of Fed hikes before mid-2013 as the
economy recovers faster than expected
Bullish risks to the view
 A deeper slowdown of the global economy or
exacerbation of the European debt turmoil dragging into
2H 2012

 Downgrades by multiple agencies of US or large “core-
European” countries (Germany, France).

JP Morgan Forecasts JPY

JPY Potential trigger events

Short-term fair value model for JPY
 Our short-term model based on US-Japan rate spreads
suggest a value of 80.90, which is above current levels
 Explanatory variables: US-Japan 1 year forward 1 month
rates

Short-term model vs. JPY actual

Long-term fair value model for JPY
 Our long-term model suggests a USD/JPY fair value of
114, which is well above current levels.
 The model is based on structural factors including
government debt, terms of trade, productivity growth,
and net investment income

 The JPY’s large overvaluation is driven by its high
debt/GDP ratio. This result may be overstated given that
most Japanese debt is domestically owned. If we were to
scale down the Japanese debt variable by 75%, 50%, or
25%, the USD/JPY fair value estimate would change to
101, 90, or 81, respectively.

Medium-term technical view
 The medium term technical view for USD/JPY is
unchanged, as new lows are still expected. However, we
recognize the current consolidation phase above the
October lows has persisted much longer than expected.
Moreover, the price action for JPY crosses has proved to
be more resilient than anticipated given the advances
from the January lows amid an improved risk backdrop.

Still, the price action for USD/JPY since the 4Q lows
continues to reflect a corrective bias rather than a basing
pattern consistent with the overall bearish view for new
lows. Violations of the 76.54/30 support area confirms
this view. The 78.23 December high and 78.37, 200-day
moving average will now act as key initial resistance.

However, a break above the 79.54 October peak is
necessary to suggest the prospects for a test, if not break
of the 75.31 low have been greatly diminished.

Correlation with yield spreads suggest
EUR/JPY could rebound in short-term
 Peripheral yield spreads (with the exception of Portugal)
against Germany has been tightening since the beginning
of the year. Italy-German 10-year yield spread is at levels
last seen in early December of last year. Past correlation
between this yield spread and EUR/JPY suggests that
despite the 4% rally from the recent trough, there could
be some room for further upside for the pair at least in
the short-term.