BoJ Preview BoJ set to meet high expectations

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1 Investment Research General Market Conditions 27 July 2016 BoJ set to meet high expectations We expect the Bank of Japan (BoJ) to cut its policy rate by 20bp to -0.3% and expect additional qualitative measures, including an upscaling of ETF and J-REIT purchases. We believe our forecast of BoJ easing will be a moderate positive surprise to the market compared with current pricing. We expect the Japanese Government to announce a substantial fiscal stimulus package with a direct economic effect of JPY6trn (1.2% of GDP). We do not expect the BoJ to adopt helicopter money measures in the sense of a permanent increase in the monetary base or in the form of direct BoJ underwriting. We expect USD/JPY to bounce 2-3 figures on the policy announcement but we do not look for a sustained rally in USD/JPY. On a 3-12M horizon, we expect USD/JPY to stabilise as further negative interest rates and continued portfolio outflows out of Japan would help to underpin USD/JPY and thereby counter the underlying support for JPY stemming from fundamentals. We target USD/JPY at 107 in 3M and 108 in 6-12M. We expect Japanese yields to inch lower across the JGB curve and expect the curve (2Y10Y, 5Y30Y) to bull-steepen following the announcement. Lower Japanese yields are likely to have implications for both Treasury and Bund yields. BoJ to react to weak growth outlook We expect BoJ to cut interest rates and add qualitative easing We expect the BoJ to react to sluggish growth outlook, low inflation and the strong JPY appreciation seen this year by announcing a substantial easing package in connection with the monetary policy meeting on July. We expect the BoJ to cut the IOER rate applied to the policy rate balance of current account deposits by 20bp to -0.3% and expect it to announce additional qualitative measures including an upscaling of ETF and J-REIT purchases (real estate investment trusts) from the current JPY3trn and JPY90bn, respectively, while maintaining its current quantitative target of Japanese government bonds purchases of PY80trn annually. Negative interest rates have been heavily criticised since the introduction in January. In particular, the banking sector is under increasing pressure with negative rates. In order to avoid a possible tightening in financial conditions due to eroding earnings in the banking sector caused by negative interest rates, we expect the BoJ to cut the interest rate on its loan support programme to negative (similar to what the ECB did with its TLTRO II programme by making loan rates negative) and believe it is also likely to expand the list of eligible collateral for BoJ loans. Monetary easing accompanied by fiscal stimulus In addition to the monetary easing from the BoJ, we expect the Japanese Government to announce a substantial fiscal stimulus package in the magnitude of JPY25-30trn (overall package including loans to businesses) with direct economic effects of JPY6trn (1.2% of GDP). This is more or less in line with communications from Japanese officials and in the media following Prime Minister Shinzo Abe s ruling coalition s big victory in the Upper House elections on 10 July. According to several media, the fiscal stimulus package could be announced already next week. and low inflation/expectations Senior Analyst Morten Helt mohel@danskebank.dk Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk Important disclosures and certifications are contained from page 4 of this report.

2 A package of stimulus currently appears to be the most powerful solution to boost the growth outlook and sentiment. However, given the already significant size of the BoJ s asset purchase programme, the combination of public spending and additional monetary easing has once again raised the debate about helicopter money especially after BoJ s Kuroda and Prime Minister Shinzo Abe met with former Fed president Ben Bernanke earlier this month. We do not expect the BoJ to adopt helicopter money measures in the sense of a permanent increase in the monetary base or in the form of direct BoJ underwriting. This is also one of the main reasons we think the BoJ will refrain from expanding its programme of JGB purchases further. BoJ set to meet high expectations The market has extremely high expectations for this week s BoJ meeting, which has supported the past week s rise in the Nikkei and USD/JPY. According to a Bloomberg survey, 32 of 41 economists expect the BoJ to ease policy this week. However, given the BoJ s multi-dimensional policy space (quantitative and qualitative easing with negative interest rates), it is very difficult to estimate what the market has priced in. Moreover, rising expectations of a large fiscal stimulus programme have also been a supporting factor for Japanese equities and a weakening of the yen in recent weeks, which only makes it even muddier. In line with us, most economists expect easing in the form of a mix of policy measures. According to the Bloomberg survey, 72% of respondents in the survey forecast the BoJ will increase ETFs purchases and 64% expect a further cut to a negative interest rate, while 46% expect an increasing amount of JGB purchases. We estimate that 10-12bp worth of rate cuts has already been priced in the Japanese money market, while the overnight interest rate is priced to fall to -0.27% by the end of We believe our forecast for BoJ easing will be a moderate positive surprise to the market compared with current pricing and, over the short term, we think the combination of fiscal and monetary easing could support a stabilisation in Japanese markets via improved risk sentiment and a more positive growth outlook. USD/JPY outlook: higher short term; range medium term We expect USD/JPY to bounce 2-3 figures on the policy announcement but we do not look for a sustained rally in USD/JPY. However, a knee-jerk break above the strong technical resistance level of (see Danske Technical Update, 27 July) should not be ruled out, as stretched long JPY positioning combined with USD/JPY being oversold according to our short-term financial model implies that a BoJ easing could have an effect on USD/JPY this time around. High easing expectations: USD/JPY and Nikkei have risen Source: Macrobond Financial, Danske Bank Markets Market s pricing of BoJ 0.00% -0.05% -0.10% -0.15% -0.20% -0.25% -0.30% -0.35% -0.40% Pricing JPY-OIS 1m swap -0.45% Jul16 Oct16 Jan17 Apr17 Jul17 Oct17 Current live Investors are speculatively long JPY USD/JPY significantly oversold Source: Commodity Futures Trading Commission, Macrobond Financial, Danske Bank Markets 2 27 July

3 On a 3-12M horizon, we expect USD/JPY to stabilise as further negative interest rates and continued portfolio outflows out of Japan help to underpin USD/JPY and thereby counter the underlying support for JPY stemming from fundamental flows and valuations. In this respect, we note that valuations no longer are stretched. According to our Medium-Term Valuation model (MEVA), USD/JPY at is fundamentally justified. Moreover, we think that the combination of fiscal stimulus (less domestic savings) and a higher oil price is likely to weigh on Japan s current account balance in coming years. We target USD/JPY at 107 in 3M and 108 in 6-12M. Danske Bank s JPY forecast USD/JPY close to fair value (MEVA) Forecast Spot +3m +6m +12m Exchange rates vs JPY USD EUR DKK SEK NOK Fixed income implications support for US treasuries We expect Japanese yields to inch lower across the JGB curve and expect the curve (2Y10Y, 5Y30Y) to bull-steepen following the announcement. In particular, long-dated JGB yields have been volatile this year and Friday might be no exception. We plan to keep an eye on the size of the rate cut and the quantitative measures and, importantly, on whether the BoJ lengthens the duration target for its bond purchases as some analysts have been speculating could be an option. If this happens, the effect on the long-end of the curve could be more pronounced. Ten-year JGBs are currently trading at a record low of -0.30% but if we are correct that the market is not priced for a 20bp rate cut, we could see 4-7bp downside for 10Y yields following the announcement, which could also have implications for both Treasury and Bund yields. A new move lower in JGB yields would reinforce the move from Japanese investors towards higher yielding bonds abroad. The charts below show accumulated purchases of foreign bonds by Japanese investors. In particular, US Treasuries and French bonds in Europe have been popular. Japanese bond investors favour US Treasuries In Europe, they favour French bonds Source: Bloomberg, Macrobond Financial, Danske Bank Markets Source: Bloomberg, Macrobond Financial, Danske Bank Markets Note though that the new fiscal measures announced this week should add JGB supply to the market, mitigating some of the downward pressure on JGB yields from the BoJ measures July

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