Rational overshooting in the foreign exchange market will most likely send the yen to 170 or above versus the dollar as global investors test the mettle of the new Takaichi government.
While we think fair value of the yen sits near 157, which is at the upper end of consensus forecasts of 145 to 158, investors will be testing the new government’s approach of putting a priority on growth and investment while reducing the level of debt.
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To be sure, the interest rate differential between the Bank of Japan and the Federal Reserve that supports a nearly trillion-dollar carry trade will continue to put downward pressure on the yen.
That pressure is an important reason why we think conditions are ripe for a move to 170 later this year and is a useful reminder of just how important the yen is in global finance.
Japanese growth prospects, recovery in its equity market and a narrowing of the debt-to-GDP ratio, which is the new fiscal anchor put forward by the Takaichi government, depend on the government’s more flexible fiscal framework that supports expansionary policies and investment.
The shift in approach aims to bolster economic expansion over austerity through sustained nominal growth. The national debt stands at 204% of GDP, the highest among developed economies, with raw gross debt estimated to be somewhere between 234% to 248% of GDP.
To put this debt in context, the U.S. carries a debt-to-GDP ratio of 120%.
While approximately 88% of Japan’s debt is held by domestic financial institutions and residents, it is understandable why global investors have pushed down the yen versus the dollar during the initial stage of the Takaichi administration’s economic policy.
The government faces a daunting challenge: It will need to deliver both on growth as well as rising tax revenues while engineering a decline in the debt-to-GDP ratio.
If that takes place, it will dampen the mild speculative attack on the national currency and be rewarded with a stronger yen next year.
Although I expect the Bank of Japan to hike rates by 25 basis points at its December meeting, the combination of central bank jawboning and rate expectations will not be enough to dampen excess speculation.
For that reason, the Bank of Japan will most likely need to intervene into the currency market to avoid a disorderly unwind of the yen as the central bank buys time to give the government’s policies a chance to work.
But investors are rarely that patient. During my recent trip to Japan to speak on the global economy it was quite clear to me that the financial community in Tokyo is prepared to push the yen toward 170 in a true test of the Bank of Japan, Ministry of Finance and the Takaichi government.
