FX Outlook 2018 – 10y yield target crucial for yen

by: Georgette Boele

In this publication: The yen outperformed the dollar in 2017 but weakened versus the euro. USD/JPY will rise moderately in 2018 because of a widening 10y US-Japan yield spread. A less accommodative monetary policy by the BoJ in 2019 will result in a smaller 10y US-Japan yield spread and a lower USD/JPY. The ECB deposit rate hikes should overshadow the BoJ move.

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The yen outperformed the dollar in 2017 but weakened versus the euro…

So far in 2017 the Japanese yen has outperformed the US dollar by to 5% while it has weakened by 7% versus the euro. Weakness in USD/JPY was mainly because of general US dollar weakness driven by lower 10y US Treasury yields, lower expectations about president Trump’s policies and a deterioration in sentiment towards the US dollar. EUR/JPY has mainly reflected strength in the euro across the board because of strong eurozone growth momentum, expectations about a less accommodative monetary policy by the ECB and a general improvement of eurozone sentiment because of lower perceived political risks. In this report we focus on the outlook for the Japanese yen for 2018 and 2019.

The yen to be under some pressure in 2018

For 2018 we expect USD/JPY to move modestly higher towards 115. Taking out this level of 115 will be difficult because exporters will probably have sell-orders around this level. One important driver of the yen versus the dollar is the spread between 10y US Treasury yields and Japanese government bond yields. USD/JPY moves often in tandem with this spread. We expect this spread to widen in 2018 because of our forecast for a rise in 10y US Treasury yields to 2.6%. Japanese 10y government bond yields are being kept by the Bank of Japan, which is purchasing bonds to keep yields close to zero.  We don’t expect a change in the target in 2018 even if Mr Kuroda’s term expires in April of 2018. Even though we expect the 10y yield spread Germany-Japan to increase as well, EUR/JPY has a lower tendency to move with this spread. So it should give some support to EUR/JPY, but it is unlikely that EUR/JPY will rally strongly because of this.

Second, the 10y real rate spread US-Japan is also an important factor. This factor is positive for USD/JPY as we expect a somewhat higher inflation in Japan. As the 10y Japanese government bond yield is fixed by monetary policy, such an increase in Japanese inflation will probably weigh on the yen via a less favourably real yield spread.

Third, the divergence between monetary policy of the Fed and the Bank of Japan will increase as it is likely that the Fed will continue to tighten monetary policy (2 rate hikes of 25bp in 2018 in our view) while the Bank of Japan will stand pat. This should support USD/JPY. As we don’t expect much change of the ECB monetary policy in 2018, so EUR/JPY will probably be range-bound.

…but strength versus the US dollar in 2019 and weakness versus the euro

In 2019 we expect that the Bank of Japan will signal that monetary policy will likely become less accommodative. We expect the Bank of Japan to lift the yield target to 20bp. This will have a positive impact on the Japanese yen. This is because 10y Japanese government bond yield could start to catch-up with 10y US Treasury yields. As a result, the 10y US-Japan yield spread will narrow and this will weigh on USD/JPY. On the other hand, we expect the Fed to hike twice by 25bp in 2019 so this should dampen the downside in USD/JPY somewhat. In 2019 we expect the ECB to hike the deposit rate twice to -0.2%. This and expectations of more rate hikes to come should support the euro versus the yen. All in all, we expect the yen to strengthen versus the dollar because of a narrowing 10y yield spread and general dollar weakness, while euro strength will probably be more pronounced than yen strength in 2019.