Following last week’s decision by the Bank of Japan to expand its bond purchase program further than expected in a final bid to fight deflation, the yen has depreciated aggressively. Last week it fell by almost 6% against the USD and by more than 7% against the euro, with further weakness again this week. Also last week, long-dated global interest rates moved sharply lower, including yields on Spanish, Italian and French 10 year government bonds, which fell by around 25bps despite the recent political turmoil in Cyprus and Portugal. Indeed, while so far there is no hard evidence to suggest that Japanese investors are responsible for recent JPY depreciation or lower European bond yields, there is admittedly a striking coincidence between these two developments and a stronger euro. In a recent study, our Asian economist identified significant inflows to European government bonds from Japanese investors during the fourth quarter of last year. Given poor Japanese fundamentals and current Bank of Japan (BOJ) policy objectives, it seems entirely logical with local investors searching for any alternatives to domestic bonds to boost returns. At present, the Japanese 10 year bond yield is 0.52%. Nevertheless, so long as domestic investors face deflation the real return will remain positive. However, assuming the BOJ were to succeed in raising Japanese inflation towards its new target of 2%, yields would need to increase substantially from current levels to continue to generate a positive real return. However, due to the BOJ being on the bid side that will hardly be the case, with a substantial negative real return on such holdings more likely. Going forward we believe the reasons for being hostile to the yen remain intact. However, it is equally important to consider who will benefit most. Given current bond yields, the answer may well include peripheral Euro-zone countries and the euro.
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