Japan’s economic outlook remains gloomy but the yen’s future could be bright

The combination of the pandemic, economic headwinds and tense relations with China might not seem encouraging for Japan, but appearances can be deceiving
The yen often exhibits safe haven characteristics, trading anti-cyclically and gaining in strength when investors are downbeat

Neal Kimberley

Published: 2:30pm, 14 Sep, 2021

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Japan’s economy grew at a faster-than-expected pace in the second quarter this year, but there are dark clouds on the horizon. Japan’s key automotive sector continues to face headwinds from bottlenecks in global supply chains, Tokyo’s relations with Beijing are somewhat strained and Japan remains in the grip of Covid-19.

That might not immediately seem like a supportive combination for the yen, but first glances can be deceiving.

Revised data from Japan’s Cabinet Office, released last week, showed the Japanese economy grew by 1.9 per cent from April to June. That was above the median forecast of a 1.6 per cent rise expected by economists polled by Reuters, and significantly higher than the official preliminary estimate of a 1.3 per cent expansion.

But that is where the good news basically ends. Last Friday saw Toyota Motor Corp, the world’s largest carmaker, cut its target for annual production by 300,000 vehicles as output at components factories in Malaysia and Vietnam was affected by Covid-19, accentuating existing supply chain problems caused by a global shortage of automobile chips.

Meanwhile, in China, the world’s biggest car market and a key sales area for Japanese carmakers, those same supply chain constraints helped fuel a 17.8 per cent year-on-year fall in vehicle sales in August.

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Neither are China-Japan relations particularly harmonious at present, with Beijing expressing “strong dissatisfaction and firm opposition” following recent visits by Japanese cabinet members to the Yasukuni Shrine. Meanwhile, the decision by Chinese authorities to close the Tang Little Kyoto project in Dalian, characterising it as a “cultural invasion”, generated heavy criticism in Japan.

As for the Covid-19 pandemic, despite the best efforts of the Japanese authorities, there have been increasing case numbers and different variants being recorded. As a consequence, last week saw the state of emergency in Tokyo and many other areas being extended until the end of September.

Despite all this, the yen traded sideways last month. Japan’s MUFG Bank noted recently that, “the yen was close to unchanged versus the US dollar in August and initial strength on a Trade Weighted Index basis also reversed to leave the Nominal Effective Exchange Rate close to unchanged in August after a 1.5 per cent gain in July”.

As for the Bank of Japan’s Real Effective Exchange Rate (BOJ REER), MUFG Bank notes that it “has declined by 12 per cent since peaking in May 2020”.

Pandemic economics: why the yen is rising as Japan’s economy slumps

The yen often exhibits safe haven characteristics, trading anti-cyclically and gaining in strength when investors are downbeat, and being sold when market spirits rise.

Consequently, the rise in the BOJ REER to May 2020 arguably represents market negativity at the onset of the pandemic while the subsequent reversal is a reflection of the reflation trades that were established as markets became more optimistic about global economic prospects.

Fast forward to today and there is an argument that the pendulum is about to swing back towards a degree of yen appreciation. With signs of the Chinese, American and Japanese economies running into choppier waters again, a degree of risk aversion could be about to creep back into market psychology.

Looking ahead to the second quarter of 2022, MUFG Bank envisages the yen having made gains against the US dollar as well as the yuan and euro.

There are counterarguments, of course. HSBC recently suggested that while the yen “is an anti-cyclical and safe haven currency”, it is also “highly sensitive” to US central bank actions.

Where markets see global growth momentum ebbing but the US Federal Reserve tiptoeing away from its current ultra-accommodative monetary policy settings, the yen might be “pulled in two directions”.

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Taking the view that the Japanese currency is undervalued on the foreign exchanges, HSBC expects it “to outperform many currencies going forward, but not necessarily the US dollar”.

Many will take an opposing view and feel the outlook for Japan’s economy is incompatible with yen strength. That is what makes a market.

But the key to understanding the way the yen will perform in the coming months necessitates looking beyond Japan’s own prospects. The optimism that underpinned the global reflation trade and drove yen weakness was predicated on a belief that the world economy was bouncing back from the pandemic.

That optimism has arguably faded. Although the prospects for Japan’s economy are clouded, the outlook for the yen could well be bright.

Neal Kimberley is a commentator on macroeconomics and financial markets