Picking a favorite FX trade for 2016 is tricky because of the length of time and increasing volatility in global markets. One currency pair stands out: GBP/JPY. More damage is seen in the British pound ahead, especially against the Japanese yen.
The sterling’s decline caught the market’s attention in October when a combination of negative inflation figures and stalling business activity pushed expectations of a Bank of England (BoE) rate hike beyond Q2 2016. Plummeting oil prices and the previous impact of the strong pound have made “deflation” a regular term among the mainstream media.
BoE chief economist Andy Haldane stated in early December that downside inflation risk was getting worse four weeks after the BoE made sharp downward revisions to growth and inflation. Haldane added there was evidence that earnings growth was starting to slow. In addition to a dovish central bank, the UK Treasury has been forced to make prolonged budget cuts across a number of cabinet departments as defense obligations back the UK decision to join the allied strikes in Syria.
Before deflation became a problem for the pound, the swelling current account deficit had been a red flag for the past five years, but of no immediate concern. Today, the imbalance has reached a record 6% of GDP, nearly triple 2011 levels. The swelling current account deficit explains the increasing bouts of selling facing the pound each time markets enter risk-off phase. And as investors lose confidence, risk aversion drives capital into current account surplus currencies such as the yen and the euro.
Gone are the days when yen selling was the most popular forex trade. The 2013-2014 damage resulting from Prime Minister Shinzo Abe’s all-out quantitative easing is behind us. Inflation may be at a modest 0.3%, but is well above the -1.0% average of the past five years. Contrary to many who had expected further QE from the Bank of Japan (BoJ) in Q4 2015, we stuck with our long held position that the BoJ would stand pat throughout 2014 and 2015. Japanese corporate profits have improved, GDP was revised out of recession and the BoJ has grown less pessimistic with the economy. All reasons not to add to QE, even if that means the BoJ’s 2.0% inflation target will take time to materialize.
The other reason we’re not expecting any more QE from Japan is a matter of supply and demand. After rocking global markets with its 2014 decision to raise QE by ¥15 trillion to ¥20 trillion per month, the BoJ may have finally reached its limit. At the current pace of asset purchases (which include Japanese Government Bonds and equity ETFs), by end of 2017 its holdings of JGBs would have risen from ¥200 trillion to ¥500 trillion. The BoJ will have to buy ¥40 trillion from existing holders to hit its ¥80 trillion per-year goal in bond buying. It will be difficult for the central bank to find other sellers/owners of JGBs from insurance companies and pensions funds as these will simply not sell. Insurers need JGBs for asset-liability balancing, while pension funds such as the Japanese Pension Investment Fund (the world’s biggest) have disposed of enough JGBs as part of their bonds-to-equities rebalancing.
As long as global equity indexes remain reluctant to take out their 2015 highs, the chance of renewed risk aversion dragging them to their August lows remains, while JPY-strength-reversion becomes the norm.
Expecting no 2016 rate hike from the BoE and no more QE from the BoJ, we remain bearish GBP/JPY. Episodes of emerging risk appetite will likely see the pair retest and fail near 190, but the underlying trend is most likely to see a decline toward 176. A break below 175 could potentially give way to 159-162.