Commenting on the Bank of Japan’s easing of monetary policy Jaco Rouw, Core Fixed Income Investment Manager ING IM, predicts further yen depreciation.

The BoJ surprised markets by announcing a very aggressive easing of monetary policy. As a result of this, the BoJ’s balance sheet is expected to increase from JPY 167 trn now (34% of GDP) to JPY 220 trn (45% of GDP) by the end of this year and JPY 290 trn (60% of GDP) by end of 2014. With this, the BoJ is clearly outpacing the Fed and the ECB.

In terms of asset purchases, the BoJ will buy ‘only’ around 60 bn per month versus USD 85 bn for the Fed. However, relative to GDP this is 11.9% (annual) in Japan versus 6.8% in the US. In terms of net bond issuance, the BoJ is buying 160% this year versus 60% for the Fed.

Currency markets seemed to focus on the sharp increase in Japan’s monetary base relative to the US, and pushed USD/JPY higher after the announcement. With FX markets clearly focusing on which central bank is most willing to stimulate economic growth and higher inflation, this move makes sense.

From a theoretical point of view, however, one should question how this transmission mechanism is working. Higher inflation would indeed be one reason for a weaker currency (from a PPP point of view). But it can be questioned whether this is already impacting the yen. Admittedly, break-even inflation has gone up by 75 bps since Abe started to announce his reflation intentions in November last year. However, this move is a continuation of higher BE inflation that we have witnessed since 2009 when it reached extremely distressed levels of -4%.

Japanese 10,000 yen note (PD)

Japanese 10,000 yen note (PD)

Another, and probably more important transmission mechanism, is a capital flow argument. With the BoJ now a major buyer of JGB’s, expectations are that Japanese investors in JGB’s – mainly banks, insurance companies and pension funds – will start to allocate part of their money to foreign assets. This might partly be on an unhedged basis if the BoJ successfully creates expectations of a weaker yen.

As almost all yen weakness so far has been driven by the international financial community, this Japanese flow should be the next leg of further yen depreciation.

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