FX Strategy USD/JPY is back in business - we target 114

Investment Research 11 September 2014 FX Strategy USD/JPY is back in business - we target 114 USD/JPY has recently broken the early 2014 high of 105.50 and is now back to 2008 levels. The upside break of the post global financial crisis high is important, both fundamentally and technically and we see more upside in the pair. Three things point to a weaker JPY leg: a reform of the investment strategy of the Japanese Government Pension Investment Fund, portfolio flows and eventually more easing from Bank of Japan (BoJ). We revise our short-term USD/JPY forecasts higher on pension reforms and portfolio flows but maintain our 12 months USD/JPY forecasts at 114. We recommend leveraged funds to buy a three-month USD/JPY ratioed seagull, exploiting elevated vols and limiting the downside in case of a USD/JPY retracement. Scandinavian corporates should hedge JPY expenses through forward extras. Forecast change USD/JPY 1M at107 (previously) 3M at 110 (105) 6M at 112 (110) 12M at114 (unchanged) FX economics Pension fund reforms to drive increased foreign bond allocations The Japanese Government Pension Investment Fund (GPIF) is the world s largest public pension fund and currently manages capital of JPY127.3trn. Although it is an independent administrative institution with the mission of managing and investing the Reserve Funds of the Employees Pension Insurance and the National Pension, it is monitored by an investment committee and is currently subject to the requirement of investing 60% of funds in domestic bonds with a buffer of 8 percentage points. The latest figures for the GPIF portfolio allocation show that the share of domestic bonds is very close to the 52% lower bound (see Figure 1). Consequently, the fund cannot decrease its share of domestic bonds further without a change in the weight requirement. Figure 1. GPIF allocation shifts to drive JPY weakness GPIF portfolio allocation (end-june 2014) Shortterm assets, 2.3% 11.1% 16.0% 17.3% Source: GPIF, Danske Bank Markets 53.4% allocation post a weight reshuffle Shortterm assets, 2.3% 22.0% 15.1% 20.6% 40.0% Analyst Kristoffer Kjær Lomholt +45 45 13 78 67 klom@danskebank.dk Senior Analyst Morten Helt +45 4512 85 18 mohel@danskebank.dk Head of FX and Commodities Strategy Thomas Harr +45 45 13 67 31 thhar@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com

We expect such a change in the weight requirements to be announced in the coming months, as we see the timing as suitable: BoJ s asset purchases continue to drain liquidity in Japanese bond markets, which not only makes Japanese bonds less attractive but also limits the scope of further bond purchases by BoJ. A weight reshuffle would be regarded as part of Prime Minister Abe s plan to reform Japan after taking office in 2012. Not only would a reshuffle of the current conservative strategy improve returns but it will also stimulate risk-taking at home by funnelling money into Japanese investments. The responsibility for a change in weight requirements falls with the Health Ministry. The appointment of Yasuhisa Shiozaki as new Health Minister has increased speculations of pension reforms given his image as a pro-market reformer. Specifically, we expect the 60% share target of domestic bonds to be reduced by 20pp and that the released funds will be distributed by increasing the share of domestic stocks by 10pp, the share of foreign stocks by 6pp and the share of foreign bonds by 4pp (Figure 1). Assuming an unchanged level of capital from June 2014, modifying the portfolio weights would lead to an net-outflow of JPY12.7trn, which would drive JPY weakness. In addition, public pension funds are likely to jump on the bandwagon and increase allocations of foreign assets. In the past months Japanese purchases of foreign bonds have increased, which historically has been an important driver for USD/JPY. The recent flows out of Japan may reflect the recent increase in GPIF s share of foreign bonds but as argued above, further increases are not possible before the portfolio weights have been officially modified. Using the estimated portfolio weights above GPIF would have to net buy JPY5.1trn worth of foreign bonds. Since the latest GPIF release (end-june 2014) Japan has been a net buyer of foreign bonds with a net worth of JPY1.9trn. As a result, even if we assume all net purchases can be attributed to the GPIF, there is still significant room for more bond purchases, which would weigh on the JPY. Figure 2. Portfolio flows weigh on basic balance Figure 3. Japanese purchases of foreign bonds have increased Figure 4. Japan has lost market share to competitors despite a weaker JPY JPY bn 8,000 6,000 4,000 2,000 0-2,000-4,000-6,000-8,000 8W Japanese net bond outflow (lhs) USD/JPY (rhs) 107 105 103 101 99 98 JPY bn Current Account FDI 5,000 Portfolio Flows Basic Balance 4,000 3,000 2,000 1,000 0-1,000-2,000-3,000-4,000 Jan/13 Apr/13 Jul/13 Oct/13 Jan/14 Apr/14 Jul/14 Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets Source: Macrobond, Danske Bank Markets Due to a deteriorating trade balance and portfolio flows, the basic balance has started to weigh on the JPY (see Figure 2 and Figure 3). In addition, the Japanese trade balance has since 2011 worsened significantly and only a strong income balance has limited the current account deficit. In addition, Japanese competitiveness has been surprisingly weak in the wake of the 2011 earthquake (see Figure 4). Bank of Japans monetary policy to remain accommodative As expected, BoJ did not announce any additional easing measures at the September meeting. Despite the subdued recovery in retail sales in the wake of the April sales tax hike and falling inflation expectations, the BoJ minutes reveal that there are no signs of 2 11 September 2014 www.danskeresearch.com

imminent further monetary easing. Moreover, recent JPY depreciation and the expected GPIF reform tend to postpone further monetary easing. Hence, we expect that BoJ easing will be postponed until 2015 with the risk tilted towards Q2. We see three options for additional easing: (1) an increase in the monetary base; (2) increased purchases of ETFs and REITs, and (3) a cut in the interest rate on excess reserves. In any case, relative monetary policy will remain a supportive factor for USD/JPY (Figure 5). In light of the Japanese 2020 budget target, its current 7% budget deficit and the forthcoming second round of sales tax hike (in October 2015) we still believe that BoJ eventually will be forced to ease monetary policy further to reach its 2% inflation target. Contractionary fiscal policy and easing monetary policy remain the main anchor for our call of a weaker JPY in the medium to long term. Figure 5. Aggressive BoJ easing Source: Macrobond Figure 6. Inflation expectations have declined The USD as an asset currency We continue to believe that the market is underestimating the Fed and that a re-pricing of the first Fed hike will support the USD going forward (Figure 7). Importantly, however, we believe that USD strengthening is less dependent on Fed pricing than previously, since the USD has increased its status as an asset currency. The USD simply delivers a higher expected return no matter whether one invests in equities or real assets. For example, the spread between 10Y UST and 10Y Bund yields is at its highest level since 1999 (Figure 8). The rally in the USD has coincided with the rally in risk appetite in line with the USD developing the characteristics of an asset currency. FX outlook Short-term (0-3 months) Higher We are changing our USD/JPY forecasts due to GPIF reforms and portfolio outflows. As such, we expect the USD/JPY appreciation to play out over the coming 3-6 months and adjust our 1M, 3M and 6M USD/JPY forecasts to 107, 110, and 112, respectively, from, 105 and 110. In the short term, we note the significant positioning risks, as short JPY positioning is at very stretched levels (see Figure 11 and Figure 12). According to CFTC IMM data, non-commercial JPY and USD positioning has become markedly more stretched in recent weeks. As such, we believe that USD/JPY could consolidate near term around current levels, before the next leg. Medium-term (3-12 months) targeting 114 Source: Bloomberg, Danske Bank Markets Figure 7. The market underestimates the Fed Source: European Central Bank Figure 8. 10Y UST-Bunds spread at its widest level since 1999 We maintain our 12-month USD/JPY forecast at 114. Fiscal tightening and an ultra-loose monetary policy will drive USD/JPY higher. Our purchasing power parity (PPP) USD/JPY model puts the fair value at around 85, while the JPY real effective exchange rate (REER) is around 25% below the average since 1994, suggesting that the JPY is significantly undervalued. This should limit JPY weakness in the long term. Source: Macrobond, Danske Bank Markets Figure 9. Danske Banks JPY forecasts Forecast Spot +1m +3m +6m +12m Exchange rates vs JPY USD 107.0 107 110 112 114 EUR 138.3 139 140 141 143 DKK 5.38 5.36 5.33 5.29 5.21 SEK 6.64 6.62 6.50 6.38 6.15 NOK 5.93 5.83 5.68 5.57 5.42 Source: Danske Bank Markets 3 11 September 2014 www.danskeresearch.com

FX strategy Leveraged funds 3M USD/JPY implied looks expensive when evaluated by a Z-score of the differential between implied and realised volatility (Z-score of +2.39 with seven-year data history). As such, we find strategies with high delta and short vega profiles attractive. Specifically, we recommend leveraging funds to enter a ratioed 3M seagull by buying an ATMF USD/JPY call (spot ref..94), selling a 3M USD/JPY 110.75 call and selling a double notional 3M USD/JPY 103.75 put (these are indicative levels and clients should check live prices with their sales manager). As figure 12 shows, this strategy is profitable if USD/JPY at maturity trades above spot, while profits will be capped at 110.75 (our 3M forecast is 110.00). In addition, the strategy limits losses relative to an outright long position if USD/JPY at maturity trades below spot ref. but above.55. We expect BoJ to step up its monetary policy easing should USD/JPY fall sharply below. In other words, we believe an implied BoJ USD/JPY put increases the attractiveness of the ratioed seagull strategy. Finally, the ratioed seagull strategy is attractive relative to an outright spot position as it limits losses should USD/JPY correct in the short run. In light of the recent move higher in USD/JPY and the historically stretched positioning, we cannot rule out such a short-run correction. In sum, we find the rationed seagull strategy a very attractive way to position for a higher USD/JPY. Real money funds For Scandinavian pension funds, which manage their FX risk actively, we recommend to increase FX hedges against JPY exposures. We expect the JPY to underperform broadly, including versus the SEK, NOK and DKK, on fundamentals and flows (see Figure 10). Corporates Figure 10. USD/JPY above 2014 highs and now back at 2008 levels 98 96 94 92 90 USD/JPY SMAVG () SMAVG (200) SMAVG (55) Mar/13 Apr/13 May/13 Jun/13 Jul/13 Aug/13 Sep/13 Oct/13 Nov/13 Dec/13 Jan/14 Feb/14 Mar/14 Apr/14 May/14 Jun/14 Jul/14 Aug/14 Source: Macrobond, Danske Bank Markets Figure 11. Non-commercial JPY short positioning is stretched at the 2 nd percentile Source: CFTC, Danske Bank Markets 98 96 94 92 90 Scandinavian corporates with JPY receivables should increase FX hedge ratios through FX forwards. Meanwhile, Scandinavian corporates with JPY payables should use hedge strategies that maintain a profit in case of further JPY weakness. Specifically, we recommend hedging JPY payables using forward extras. Figure 12. 3M USD/JPY ratioed seagull strategy is attractive relative to an outright spot position and takes advantage of the expensive implied option volatility PnL % 8 6 4 2 0-2 -4-6 -8 Ratioed Seagull Break even compared to outright.5 101 101.5.5 103 103.5.5 105 105.5.5 107 107.5.5 109 109.5 110 110.5 111 111.5 112 112.5 113 Note: The strategy is cost neutral and consists of buying 3M USD/JPY call at spot ref. strike (.94), selling 3M call with strike 110.75 and selling 3M call with strike 103.75 at double notional. Source: Bloomberg, Danske Bank Markets Indicative spot ref. USD/JPY at maturity Outright long 3M Forecast Upside limit 4 11 September 2014 www.danskeresearch.com

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