Conflicting signals on dollar-yen

The Goldman sentiment index (discussed last week) on USD/JPY is now flashing "red", with the yen looking increasingly oversold.

GS: - As JPY speculative shorts increased by another $4bn from last week, our JPY Sentiment Index fell to 0, indicating that JPY net short positioning is at its highest point in three years.

Source: GS

Clearly investors have some good reasons to continue shorting the yen, as fundamentals for the currency are terrible. The BOJ balance sheet as percentage of GDP is at a record.

Source: Merrill Lynch

And the new government will pressure the BOJ to expand its balance sheet further (see discussion).

Merrill Lynch: - ... the government will probably continue to put strong pressure on the BOJ to take necessary monetary policy action promptly. The government has a chance to exert overt influence over the BOJ through upcoming appointments to replace Governor Masaaki Shirakawa and the two deputy governors (whose terms expire on 8 April 2013 and 19 March 2013, respectively). Cooperation between the government and the BOJ could strengthen.

The BOJ is unlikely to go to such extremes as underwriting JGBs or purchasing foreign bonds because there is not much public support for such measures. Likely policy moves, though, include the setting of an official inflation target of 2%, extending the maturities of JGBs that the BOJ holds, and moving in the direction of the Fed's initiatives, such as open-ended balance sheet expansion through the elimination of limits on asset purchases.

Based on these fundamentals Merrill obviously predicts a weaker yen. As one would expect, monetary expansion is unlikely to improve credit, but it should impact the FX markets.

Merrill Lynch: - The yen/dollar rate has an unignorable impact on the trade balance, with a roughly one-year time lag. Based on quarterly data since 2007, yen appreciation by 10% narrows the trade surplus by ¥3-4tn, or 0.7-0.8% of GDP, and probably has a 0.5% deflationary impact on consumer prices. Monetary policy support for corporate lending is unlikely to have much impact [similar to QE3 in the US], as corporate financing conditions are very accommodative in Japan, but BOJ policy shifts could help weaken the yen. Based on our forex team's forecasts, we expect the yen to gradually weaken to a rate of ¥85-90/$ between the second half of 2013 and 2014.

We obviously have increasingly conflicting technical (GS) and fundamental (Merrill) signals on the yen (also see this discussion from FT Alphaville). That means a short yen bet is likely to play out in the long run, but we could see some significant volatility (due to large spec movements) on the way. Certainly going short at this stage without a long-term investment horizon would not be prudent.

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