Forex Medium-Term Outlook - Mizuho Bank · REER of major currencies （2011-2016） CNY EUR JPY USD...

Forex Medium-Term Outlook

30 September 2016

Mizuho Bank, Ltd. Forex Division

Medium-term Forex Outlook Mizuho Bank Ltd. 1

【Contents】

Overview of outlook ・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・P. 2 USD/JPY outlook – 2016 marks the beginning of the current phase of JPY appreciation against USD G4 currencies current status and future prospects – Insufficient weakening of USD is of concern USD/JPY Outlook – What extent of USD strength reversals must be forecast ・・・・・・・・・・・・・・・・P. 3 JPY basic supply and demand – Could it prevent USD/JPY falling below 100?・・・・・・・・・・ P. 5 BOJ monetary policies now and going forward – Additional easing now more difficult・・・・・・・・・P. 6 U.S. monetary policies now and going forward – Steadily retreating from the normalization process・・・P. 8 The U.S. presidential election and forex rates – Limited scope for maintaining the status quo・・・・・ P. 10 Risks to my main scenario – Factors promoting JPY appreciation relatively prominent ・・・・・・・ P. 12

EUR Outlook –EUR’s continued resistance to weakening

ECB Monetary Policies Now and Going Forward – The onus will be on the “forthcoming debating area” over which parameters need amendments ・・・・・・・・・・・・・・・・・・・・・・・・・・・P. 15 Overview of EUR area credit-, inflation-, and forex-related situations – Continued difficulty of guiding EUR downward・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・P. 17


Overview of Outlook USD/JPY continues to hold its ground despite seeming about to fall below 100 several times. One cannot help feeling, however, that the risk of the currency falling through its lower bound remains high. Just as this report has assumed since last year, the FRB’s normalization process is beginning to break down. Given the state of the global economy, if the U.S. insists on being the only country to walk the path of normalization, it is bound to invite USD appreciation leading to domestic economic suicide, which will then bring it back onto the dovish path. This point has been the central pillar of my argument since last year, and I have held that the current trend should be seen more as USD weakness than JPY strength, and I do not envisage any change in this point in 2017 – rather, it is likely to become true. During the present forecasting period, the currency policy under the new U.S. president will become an even more important factor. Judging by the information available as of the present time, continued USD depreciation is very likely to be tolerated regardless of whether Hillary Clinton or Donald Trump becomes the new president, and the FRB’s monetary policy is likely to fall in step with the currency policy. Again, even setting aside the political factors, one must not forget that the real effective exchange rate (REER) or USD still has considerable scope for downward adjustment. What is more, it is extremely rare for a phase of JPY appreciation or depreciation, once it has begun, to end within a year. I believe 2016 was merely the beginning of the current phase of JPY strength/ USD weakness and think that the trend is very likely to continue in 2017. EUR has continued to be lacking in a clear-cut sense of directionality. With the FRB and BOJ monetary policies drawing all the attention, the ECB has been banished to relatively boring news topics. Having said that, an additional monetary easing by the ECB within the year is quite possible, given its recent communications. Also, there is going to be a referendum on constitutional amendment in Italy in October, and the results of the referendum and the accompanying problems could well trigger a sale of EUR. However, the euro area’s current account surplus continues to accumulate at an average pace of EUR 20-30 billion a month (≈ JPY 2.3-3.4 trillion) and it seems quite likely that EUR will post the world’s largest current account surplus again this year. If we take the FRB’s normalization process to be breaking down already, the biggest topic for the forecasting period does seem very likely to be USD depreciation, and EUR could rise more strongly against this. In formulating my forecasting range, therefore, it is important to look into how well the ECB can suppress this EUR appreciation, and going by what we have seen so far, it does seem more capable than the BOJ when it comes to checking the appreciation of its domestic currency. As a result, even though EUR will probably inch up gradually, it seems unlikely to post any major appreciation. Summary Table of Forecasts

USD/JPY 99.00 ～ 121.70 96 ～ 104 94 ～ 102 93 ～ 102 91 ～ 101 90 ～ 100

EUR/USD 1.0711 ～ 1.1616 1.09 ～ 1.14 1.08 ～ 1.16 1.09 ～ 1.17 1.10 ～ 1.18 1.10 ～ 1.18

EUR/JPY 109.30 ～ 132.45 107 ～ 116 106 ～ 115 105 ～ 113 104 ～ 115 104 ～ 115

Oct-Dec2016

Jan-Mar Apr-Jun Jul-Sep2017

(Notes) 1. Actual results released around 10am TKY time on 30 September 2016. 2. Source by Bloomberg 3. Forecast rates are quarter-end levels

(108)

(1.1206) (1.12) (1.12) (1.13) (1.14) (1.15)

(113.28) (110) (109) (108) (108)

(94)

Oct-Dec

(101.10) (98) (97) (96) (95)

Jan-Sep (actual)

Exchange Rate Trends & Forecasts

70

80

90

100

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130

140

08/2Q 09/2Q 10/2Q 11/2Q 12/2Q 13/2Q 14/2Q 15/2Q 16/2Q 17/2Q

USD/JPY


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1.1

1.2

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EUR/USD

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95

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115

125

135

145

155

165

175

08/2Q 09/2Q 10/2Q 11/2Q 12/2Q 13/2Q 14/2Q 15/2Q 16/2Q 17/2Q

EUR/JPY

USD/JPY outlook – 2016 marks the beginning of the current phase of JPY appreciation against USD G4 currencies current status and future prospects – Insufficient weakening of USD is of concern The status of the G4 currencies Although the year-to-date USD/JPY low levels indicate a considerable weakening of USD, from the perspective of the REER, there still remains considerable scope for USD depreciation, and my basic understanding remains that the BOJ, short of purchasing foreign securities, will find it difficult to keep the wave of USD depreciation at bay no matter what policy it adopts. In this report, as part of the overall framework of factors influencing USD/JPY, I have focused on the strength/weakness relationship among the G4 currencies (USD, EUR, JPY, CNY) when preparing my forecasts. Over the past five years, USD and CNY (which is pegged to USD) have borne most of the brunt of currency appreciation, while JPY and EUR have enjoyed the benefits of currency depreciation – this fact provided the biggest hint when it came to preparing currency forecasts. Specifically, between 2011 and mid-2015, CNY and USD appreciated by around +30% +20%, respectively, while JPY and EUR depreciated by around -30% and -10%, respectively. Of course, since we have taken the year in which JPY appreciated the most (2011) to be the starting point, it would be dangerous to read too much into the absolute rate of change. Having said that, the main topic in the forex markets over the past five years has certainly been the appreciation of USD or the depreciation of JPY. Note that (as the exhibit shows) it was only in 2013 that the forex markets began to fluctuate strongly, so the trend would not look too different even if seen over the duration of just the past three years (the only reason I set the time-frame to five years was in order to take a look at the trend from before the start of Abenomics). The important point is that the REER of a currency cannot continue indefinitely with a one-sided bias under a floating exchange rate system. As the exhibit shows, the gap among the four currencies, which was at its widest last June, has been steadily shrinking since. Of course, China does not have a real floating exchange rate system, but CNY, being pegged to USD, has also been relentlessly appreciating over the past several years. Finally last August, CNY was forced to make adjustments in accordance with the principles of a floating exchange rate system (≈ will of the markets), as everyone is aware. USD, however, after a phase of relentless appreciation starting mid-2014, appeared to have entered a phase of depreciation between January and April this year, but it has since made an about turn and begun rising again without completing its adjustment. This is entirely because of the FRB’s obstinate pursuit of rate hikes, but I do not believe this appreciation of USD is sustainable for reasons I have stated many times before.

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11 12 13 14 15 16

（JAN 2011=100）

(Source)BIS (Note) Broad base

REER of major currencies （2011-2016）

CNY EURJPY USDJAN 2011=100

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CNY USD JPY EUR

（％）

(Source)BIS (Note) Broad base

Change ratio in REER

JAN 2011-DEC 2015

JAN 2016-JUL 2016

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REER↓

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70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

（Average 2010=100）

（Source）Bank of Japan

REER

REER

Long term average（20 yrs）

Insufficient weakening of USD is of concern It is easy to get the impression that the forex markets as a whole have been extremely volatile since the beginning of the year, but in terms of REER, JPY and CNY are the only two currencies that have seen much movement. USD and EUR do not appear to have undergone much of an adjustment. Rather, when it comes to USD, the reality is that it remains stubbornly high. For instance, looking at the rate of change in REER of the G4 currencies (USD, EUR, JPY, CNY) over the past five years (from January 2011 through December 2015), USD and CNY have increased by around +19% and +28%, respectively, while JPY and EUR have decreased by around -29% and -6%, respectively. Looking at the subsequent movements from January through July this year, JPY and CNY have undergone significant adjustment, with JPY increasing by around +11% and CNY decreasing by around -6%, but EUR remains more or less level, while USD has decreased by only -2% or so. Intuitively speaking, USD has not undergone sufficient adjustment given the rapid pace at which it appreciated before then. In other words, one feels that the weakening of USD has been insufficient. 95-yen rate for USD/JPY may be in sight Taking the aforementioned arguments into account, one feels that in terms of REER, USD has further scope for a fall while JPY has further scope for accrued strength. The REER of JPY fell to a level not seen since September 1972 last June, but as of July this year, it has recovered to a level last seen in January 2013, i.e., to the level it was at before the start of the Kuroda administration. The distortion compared with the long-term average (average of the past 20 years) has shrunk to around -5%. An adjustment of USD/JPY from its level as of the end of July (around 102) to correct this distortion would result in USD/JPY falling to 97 or so, and given the forex markets’ propensity to overshoot, a rate of 95 yen may also be in sight. Looking at it this way, the adjustment of the weak JPY trend over the past three years, while it has been progressing smoothly, is not yet sufficient. In the forex markets, where identifying fair value is difficult, it is also difficult to identify what the “appropriate margin of adjustment” is. However, even so, looking at the intensity of USD appreciation so far, the reversal of this appreciation is clearly insufficient. This is the result of the FRB not giving up on the idea of rate hikes and turning hawkish every time USD weakens slightly, which results in a market pattern of U.S. rate hike → USD appreciation. However, what the FRB wants at present is to normalize its monetary policy and create some scope for future rate cuts when they become necessary. The resultant USD appreciation, however, is not at all desired, and this is true also from the perspective of the U.S. political establishment as represented by the Department of the Treasury. In this sense, the present scenario is very different from the early 1980s and the late 1990s, when the U.S. promoted USD strength as a national policy. In those days, the U.S. had the capacity to magnanimously tolerate USD strength, with phrases such as “defending the dollar” and “a strong dollar is a national advantage.” At present, however, USD strength is no more than a burden for the U.S. and it is not likely to tolerate its side-effects indefinitely. At any rate, the fact that there seems to be further scope for USD depreciation in terms of REER is something worth keeping in mind, and it will be interesting to see which currency bears the brunt of currency appreciation the most in the process of USD’s adjustment. If past experience is any indicator, that currency tends to be JPY.


-30

-20

-10

0

10

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30（Tril yen）

(Source) INDB (Notes) Subject: including insurers, pension funds & individuals, excluding deposit taking finance institutions & government

Primary supply-demand balancereflected balance of international payments

Inward security investmentOutward security investment (others)Direct investmentCurrent account balance（excluding re-invested earnings）Primary supply-demand balance

-15%

-10%

-5%

0%

5%

10%

15%

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30%

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16（Source）INDB

Reinvested earnings portion of the primary balance

JPY basic supply and demand – Could it prevent USD/JPY falling below 100? Current account surplus expanded in July but is likely to shrink going forward In September, Japan's July Balance of Payments were released, I would therefore like to make a few observations about the JPY supply and demand situation. The July Current Account Balance fell short of the median of market forecasts (+JPY 2.07 trillion) at +JPY 1.9382 billion, but it did post a yoy gain of +JPY 144.4 billion. This expansion of the current account surplus was mainly driven by the Trade Balance turning itself into a surplus, being the result of imports falling further than exports – not exactly a positive development. The decline in exports reflects an international economic slowdown and the strengthening of JPY, while the decline in imports reflects a domestic economic slowdown and fall in crude oil prices. In other words, the Trade Balance merely happened to turn a surplus against the strengthening of a diminishing equilibrium trend. Taking into account the strong JPY trend since last year and this report’s forecast of further JPY strengthening, it seems unlikely that exports, the travel balance, or the primary income balance (all receipts) will increase much going forward. If so, the expansion of the current account surplus will depend entirely on how much the trade surplus can expand due to the decline in imports. Even if no significant reactionary rise in crude oil prices can be expected, it would be difficult to predict a further decline in them, so the import-decline-based expansion of the current account surplus is likely to take a break here. It would be reasonable, therefore, to predict a contraction of the current account surplus due to strong-JPY pressures in the months ahead. The current state of the basic JPY supply and demand – Could it prevent USD/JPY falling below 100? Looking at the basic supply-demand balance based on this result (see exhibit), as per data released up to the previous month, there was a net supply of JPY of around -18.7 trillion for 1H of 2016 – this is an even larger net supply than the ≈ -JPY 12 trillion posted for the whole of 2015. The recently released data for July shows a small net purchase of +JPY 1 trillion or so for a single month, but if we look only at foreign securities investment (which has driven JPY sale so far), the net acquisition of securities (JPY sale) was quite robust, so this category seems likely to dictate JPY supply-balance trends during 2H too. With JPY interest rates being lowered to their utmost limit, Japanese investors have no choice but to look abroad, so it has become difficult to imagine a scenario of net supply of foreign securities (JPY purchase) even against the backdrop of a foreign economic slowdown including in the U.S. As I have said many times before in this publication, I believe that this is the most realistic risk for my bullish-JPY forecast. Of course, one could wonder how JPY managed to strengthen thus far despite this supply-demand situation, but then there is also the argument that this supply-demand situation is the reason USD/JPY has been maintaining the 100 level. Amid soaring USD funding costs, even unhedged foreign securities investments are gradually increasing, so one has to look to the JPY supply-demand balance as an answer for why USD/JPY is not already below 100 on a stable basis. Again, as I said above, the current account surplus seems unlikely to expand much going forward. What is more, the reinvested earnings portion (earnings that are used as foreign currency without ever being converted into JPY) of the primary income balance, which is the backbone of the current account surplus, has been increasing in recent years (see exhibit). In calculating my basic supply-demand balance, I use primary income balance data excluding the reinvested earnings portion, so the above trend is likely to become another factor contributing to net sale of JPY in my basic supply-demand balance computation. At any rate, with the basic supply-demand balance continuing to clearly indicate JPY weakness, it will be important to gauge the extent to which the upper bound of JPY can be expanded in my future JPY forecasts.


BOJ monetary policies now and going forward – Additional easing now more difficult Increasingly difficult to understand At the September 21 BOJ Monetary Policy Meeting, the Bank decided to introduce a new monetary easing framework of “Qualitative and Quantitative Easing with Yield Curve Control,” under which it will control short-term and long-term interest rates. Roughly speaking, it was announced that, based on a comprehensive assessment, there would be “an end to quantity and a switch to interest rate controls,” while deepening negative interest rates and other additional easing measures were postponed. The Kuroda regime began with an all-out rejection of the “incomprehensibility” of the Shirakawa regime, but at this point, the policies of the Kuroda regime have become quite difficult to comprehend themselves, with the sudden proliferation of policy instruments. First the negative interest rate policy was introduced in January, and this time, the policy statement includes new terminology such as “yield curve control” and “inflation-overshooting commitment.” Compared with three and a half years ago, when the Bank stated simply that it would double the monetary base and achieve a 2 percent yoy rate of change in Consumer Price Index (CPI) in two years, it feels as though the BOJ has wandered quite a distance away from comprehensibility. Given that comprehensibility has been the Kuroda regime’s goal, one feels that the BOJ ought to at least have made a clean break away from quantity at this juncture, but (perhaps out of consideration for some of the committee members’ views) the JPY 80 trillion pace of purchase of long-term JGBs was preserved at least nominally speaking. It is not clear what amount of long-term JGBs will have to be purchased as a back-stage operation in order to peg the 10-year interest rates at around 0% – it could be less than JPY 80 trillion (of course, it could also be more than JPY 80 trillion). At any rate, even though the BOJ did not fully bid farewell to quantity, it has certainly begun to distance itself from it, and that does deserve appreciation. Meanwhile, the “Quantitative and Qualitative Monetary Easing with a Negative Interest Rate” (QQEN) banner, which was grandly introduced in January as “the strongest ever monetary easing scheme by a central bank in modern times,” seems to have been lowered as of the recent meeting and replaced by “QQE with Yield Curve Control.” Perhaps the Bank took into account the unpopularity of QQEN. Against this backdrop, any additional monetary easing measure that involves an expansion of the negative interest rate is likely to be considered with caution. The recent change in framework is considered an expansion of monetary easing based on the “inflation-overshooting commitment,” which is simply the introduction of a forward guidance for monetary policy, given specifically as follows: “The Bank will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food; Core CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner. Meanwhile, the pace of increase in the monetary base may fluctuate in the short run under market operations which aim at controlling the yield curve.” The Bank’s commitment is to expanding the monetary base – there is no mention of interest rates, which the Bank aimed to switch to this time. Perhaps this lack of mention of interest rates hides the option of a flexible changing of the 10-year interest rate, which is expected to be pegged to 0% going forward. At least based on a literal interpretation, it appears that the decision was essentially a forward guidance for continuing to expanding the monetary base (MB), and even this may have been out of consideration for some policy board members’ views. At any rate, it is extremely difficult to tell what is important and what is not important in the recent statement or if, perhaps, everything is important (that would probably be the official position), and one cannot help feeling that the BOJ’s policies are becoming increasingly difficult to understand. Following the recent decision, there have emerged three different variables for the BOJ to control – quantity, interest rates, and timeframe. Specifically, the BOJ will have to aim for JPY 80 trillion in terms of quantity, peg the long-term interest rate at the level of −0.1% to 0.0%, and adhere to the timeframe of “until the year-on-year rate of increase in the observed Core CPI stably exceeds the price stability target of 2 percent.” It is not easy to put it simply. Government bond “price-keeping operation” The point that drew the most attention in the recent meeting decision was probably the clear statement that “the Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent).” Needless to say, from a “price” point of view, this indicates nothing other than a dangerous government bond “price-keeping operation (PKO).” The longer a PKO is continued, the closer it will get to debt financing. But before that, there is also the concern of whether it is really possible to control long-term interest rates which, unlike short-term interest rates, are not that close to the present. Trying to figure out what extent of government bond purchases would lower the long-term interest rate to what level is entering into unknown waters. The authorities will have to grope in the dark to find the appropriate levels.


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1400

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99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

（USD/JPY）Japan-US base money ratio & USD/JPY rate

Base money ratio (BOJ divide by FRB)

USD/JPY （right axis, reversed scale）

(Source）Datastream

Incidentally, the BOJ itself has said on its website that, “It is only extremely short-term interest rates that a central bank can control. The formation of interest rates for longer maturities is best left to market mechanisms1.” Monetary policy operations going forward will be in complete contradiction of this statement. Additional easing now more difficult While it can be said that the operational variables have increased, the key focus of attention regarding the BOJ’s “next move” going forward will naturally be adjustments to the new mechanism for controlling short-term and long-term interest rates, particularly the handling of negative interest rates. Regarding the deepening of negative interest rates, BOJ Governor Kuroda has been emphasizing that he has not altered his views on undertaking additional easing if necessary, but with the new monetary easing framework, it appears that the hurdles on the path to additional easing have become considerably higher. However, if the margin of negative interest rates is increased, it would inevitably have an impact (exert downward pressure) on 10-year interest rates, which are being pegged at about zero percent. Of course, given the desire to pursue the easing course, there may be no need to consider interest rate declines to be a problematic risk factor. At this point, however, the BOJ will be facing some obstacles owing to the fact that it has not given up on “volume-based” easing measures. Under the new framework, the increases and decreases in MB observed going forward will be simply positioned as “results” of the pegging of 10-year interest rates at about zero. While the BOJ has said it will continue to have the goal of annually purchasing JPY80 trillion of long-term JGBs, Kuroda’s own statement that – “it is anticipated that the pace [of purchases] may fluctuate to some extent, either upward or downward, in order to achieve yield curve control.” – indicates that this is not a firm target. If the deepening of negative interest rates works to depress 10-year interest rates to below the “about zero percent” level, then the BOJ will decelerate its JGB purchases and reduce the level of annual purchases to below JPY80 trillion. The difficulty of predicting how much deceleration there may be in purchases going forward is probably one of the factors preventing a clear-cut trend in market price movements. Some observers have begun using the phrase “stealth tapering,” and if there is a noteworthy deceleration in JGB purchases and the market takes note of that, there is a possibility that the situation could become a factor promoting JPY appreciation. Although the BOJ is asserting that “interest rates rather than quantity will be important going forward,” believers in Soros-chart-type superstitions who have been tending to sell JPY may be disappointed. Since midway through last year (the portion of the graph within red dotted lines), the Japan-U.S. base money ratio has not been displaying a stable relationship to USD/JPY, and the lack of such a relationship has long been demonstrating the truth of the “even aggressive quantitative easing is no guarantee of JPY depreciation” truism. (One cannot help wondering how many times the truism has to be demonstrated before everyone will grasp it.) In light of this, it would be nonsense to propose that JPY repurchasing should commence when people note a deceleration in the pace of increase in “quantity.” On the other hand, it cannot be denied that there is a possibility that people inclined to believe in the power of “quantity” may place somewhat more emphasis on the word “tapering” than is necessary. In any case, it is clear that in the background of the interest rate peg introduction, the process of abandoning quantitative expansion has quietly begun, and a key task to be addressed going forward will be determining how to proceed with a retreat from quantitative expansion in a way that does not attract the attention of the abovementioned superstition believers. Easing “methods” distracting attention from easing “objectives”? Essentially, the hurdles on the path to implementing a negative interest rate deepening appear to be high because (1) such a deepening would have detrimental effect on financial intermediary functions and (2) there is concern that the shrinking of quantitative expansion may promote JPY appreciation. Naturally, if the 10-year interest rate peg level were to be reduced to below the “about zero percent” level, the magnitude of the requisite decrease in “quantity” could be limited. Because of this, there is a high likelihood that a negative interest rate deepening will be accompanied by a decrease in the long-term interest rate operational target level. In other words, even if negative interest rate deepening is undertaken, at the same time, the long-term yield will have to be pegged at a negative level below the current level of about zero. Given that the recent comprehensive assessment addressed both the technical limits of “quantity” and the detrimental effects on financial intermediary functions, it seems clear that

1 “Q&A guide to understanding the BOJ’s monetary policy operations, Commentary C” on the BOJ website.


Policy interest rate outlook as of each year end (median estimate)FOMC Date 2016 2017 2018 2019 Longer run

Jun-13 n.a. n.a. n.a. n.a. 4.00%Sep-13 2.00% n.a. n.a. n.a. 4.00%Dec-13 1.75% n.a. n.a. n.a. 4.00%Mar-14 2.25% n.a. n.a. n.a. 4.00%Jun-14 2.50% n.a. n.a. n.a. 3.75%Sep-14 2.875% 3.75% n.a. n.a. 3.75%Dec-14 2.50% 3.625% n.a. n.a. 3.75%Mar-15 1.875% 3.125% n.a. n.a. 3.75%Jun-15 1.625% 2.875% n.a. n.a. 3.75%Sep-15 1.375% 2.625% 3.313% n.a. 3.50%Dec-15 1.375% 2.375% 3.250% n.a. 3.50%Mar-16 0.875% 1.875% 3.000% n.a. 3.25%Jun-16 0.875% 1.625% 2.375% n.a. 3.00%Sep-16 0.625% 1.125% 1.875% 2.625% 2.90%

（Source）FRB

negative interest rate deepening is not considered to be a simple policy option. In this situation, it would appear that a decision to undertake additional easing will not be made unless USD/JPY has stabilized below JPY100 and threatens to descend below the JPY95 level. Given that Japanese stock prices are being supported by BOJ purchases of exchange-traded funds (ETFs), the incentive for additional easing is still further reduced. In addition, it appears that the focus of discussions about BOJ monetary policies among market participants has been shifting, moving away from easing objectives – such as the question of “how the real economy can be stimulated and prices can be increased” – and toward easing methods – such as the question of “how mutually incompatible policies can be instituted.” It seems that increasing the complexity of methods has forced outsiders to rack their brains to understand what is happening and made it difficult for them to focus on the original objectives of the methods. U.S. monetary policies now and going forward – Steadily retreating from the normalization process FOMC meeting: “No rate hikes either this year or next year” scenario increasingly realistic An FOMC meeting was also held on September 20 and 21. As predicted, a rate hike was put off, triggering JPY appreciation and USD depreciation in the markets. As I have been predicting in this report since last year, the FRB’s normalization process appears to be slowly but surely failing. The interest rate projection by FOMC members strongly forecasts one rate hike by the end of this year, but that is increasingly beginning to look like obstinacy on their parts. As I have been repeatedly saying, the most important point when it comes to the FRB’s normalization process is not whether or not there will be a rate hike, but the result or impact of one in the event that it is implemented. With the expansionary phase of the economic cycle coming to an end, and not much progress visible in terms of USD strength reversal, it is no longer practical to implement a series of rate hikes. In the Federal Funds (FF) rate projections (dot plot) by FOMC members this time, the neutral interest rate (median of forecasts) decreased again from 3.00% to 2.90% (see chart). It is a development that underscores the secular stagnation theory, which has become quite influential in some circles. If FRB Governor Lael Brainard is correct in her estimate2 that the appreciation of USD since June 2014 has had an effect equivalent to a 200 bp increase in the FF rate, then that would amount to the U.S. real economy experiencing an FF rate of 2.25-2.50%. Given that this was the predicted FF rate level for the end of 2016 as per the June 2014 dot plot, it seems the economy has already factored in the level of monetary austerity originally predicted. Incidentally, the recent FOMC member projections involve two rate hikes in 2017, but considering that the projections so far have consistently been downgraded from time to time, my assumption of “no rate hikes either this year or next year” in this report seems increasingly realistic. A rate hike before the end of the year will inevitably be seen as a last-minute push FRB Chair Janet Yellen stated that the Committee’s decision not to raise the interest rates “does not reflect a lack of confidence in the economy,” saying that it was because “the economy has more room to run than previously thought.” This sentiment is similar to what Ms. Brainard said in her speech on September 123, which brings to mind the rumor in some quarters that Ms. Brainard’s views influence Ms. Yellen thinking. Taking this to its logical conclusion, it seems possible that the Committee will not be able to take the decision to implement a rate hike based simply on recent job data, including the flattening of the Phillips Curve. The recent decision to retain the status quo was taken by an unusual seven to three majority vote, with three regional Fed governors who wanted a rate hike voting against the decision. Perhaps this reveals the difference in attitudes between regional Fed presidents of regions enjoying the benefits of full employment, and the FRB leadership (the chair, vice chairman, and governors), which is sensitive to the impact of USD appreciation and U.S. political trends. As far as one can tell from the dot plot, only three members predict that the present FF rates (0.25 to 0.50%) will be retained for the rest of the year, so at this moment one cannot say that the possibility of a rate hike before the end of the year is very low. However, even if, as Ms. Yellen says, the FRB does “not take politics into

2 Please see the September 13, 2016 Market Topic titled “Brainard’s Speech – The pride of the doves.” 3 Again, please see the September 13, 2016 Market Topic “Brainard’s Speech – The pride of the doves.”


70

80

90

100

110

120

130

30

35

40

45

50

55

60

65

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

（Source）Bloomberg

US ISM manufacturing & non-manufacturing PMI

Manufacturing Non-manufacturing50（turning point） Dollar index（right axis）

account” in its decisions, it seems hardly necessary to deliberately make a risky decision so close to the birth of a new administration. If such a decision is made, it would inevitably be seen as a last-minute push, and so is likely to be avoided in the normal course of things. Impact on forex outlook Both the BOJ and FOMC meetings are over, but this report’s forex outlook has not changed in the least. As I repeatedly emphasize, the most important point that one must take into account in preparing the forex outlook is the fact that the FRB’s normalization process is in the process of breaking down. The dot plot from a year ago (September last year) had predicted five rate hikes starting then and through the end of 2016, and around nine rate hikes through the end of 2017. As of the present time, that prediction has been toned down to one rate hike before the end of 2016 and two further rate hikes by the end of 2017 in the best case scenario. The number of rate hikes predicted has decreased to a third of the original number. It does seem likely that this trend will continue in 2017 as well, weakening USD and strengthening JPY as it unfolds. In fact, taking the economic cycle also into account, it seems appropriate to worry even about discussions of a rate hike. The logic behind my forex predictions over the past year can be summarized roughly as “the FRB’s normalization process does not inspire confidence, and the U.S. currency policy is averse to USD strength. Consequently, as part of the trend of USD depreciation, one must watch out of JPY appreciation.” This basic explanation seems likely to hold true for the upcoming one year period, so there seems no need to change it. Financial market and economic indicators restraining an interest rate hike On another note, there were several incidences of large-margin stock price drops during September stemming from concerns regarding the potential effects of a U.S. interest rate hike. However, if interest rate hike concerns can cause large drops in stock prices, then it should be understood that current economic conditions are in a state that is conducive to such drops. If the markets cannot remain stable and unperturbed in the face of an interest rate hike, then it may well indicate that now is not the best timing for a hike. With respect to the recent mood regarding a U.S. interest rate hike, it can be said that the stock market is communicating the message that now is not the best time. In fact, many U.S. economic indicators announced since the start of September have had the effect of elevating concerns about an interest rate hike and an associated appreciation of USD. The August ISM Manufacturing Index and ISM Non-Manufacturing Index figures indicate the continued presence of the “USD appreciation trap” situation that this article has discussed numerous times. In particular, the August ISM Non-Manufacturing Index figures released on September 6 were received as such a negative surprise that some were inspired to refer to an “ISM shock” phenomenon, and that ISM shock was a factor contributing the sharp drop in USD/JPY. The August ISM Manufacturing Index figure was below 50, the first time it has been below 50 in six months, and this also can be considered quite shocking. It is rather peculiar that the FRB should still be doggedly seeking to hike interest rates amid such conditions. The graph shows that the sharp appreciation of USD during the 2014-2015 period caused a large-margin deterioration of business confidence in U.S. manufacturing and non-manufacturing industries, and U.S. corporate profitability also deteriorated during this period. It is believed that the FRB’s increasing dovishness in response to the deterioration of domestic and foreign economic conditions and the sharp depreciation of USD has been a factor contributing to the moderation of those trends since the start of this year. Specifically, USD steadily depreciated during the February-April period this year, and it was at that time that the ISM Manufacturing Index recovered to 50 for the first time in a half year and the ISM Non-Manufacturing Index surged past 55. Also seen during that period was a recovery in mining and manufacturing production, which had been showing an intensifying trend of deceleration since the previous year owing to USD appreciation. Perhaps because such figures inspired it with optimism, the FRB during that time period suddenly intensified its information dissemination regarding an interest rate hike in June. Ultimately, however, that interest rate hike was not implemented owing to the combined effects of May employment statistics released in early June along with concerns about the Brexit situation.


by Daisuke Karakama, Mizuho Bank

U.S. rate hike vicious circle

FRBrate hike

Funds rushing to

USD

Srong USD（≒strong

CNY）

Unstable U.S. & China

economy

FRB getting dovish

Weak USD（≒Weak

CNY）

Stable U.S. & China

economy

Comparison of strong USD phases in the past Rate of increase（①, ％）

Years（②）

Pace of increase per year（①÷②, ％pts）

①1978-1985 34 7.0 4.9

②1995-2002 24 7.0 3.4

③2014-2016 15 2.0 7.8（Source）FRB

（Notes）REER broad base comparison between JAN of start year and DEC of end year.③from JUN2014 to JUN 2016

Renewed “USD appreciation trap” situation Subsequently, receding expectations of an interest rate hike forced a drop in USD during early and mid-June, but the results of the Brexit referendum spurred a large volume of GBP selling that facilitated a trend of sharp USD appreciation from late June through July. Although that trend moderated during early and mid-August, rising expectations of a September interest rate hike restored USD’s robustness from late August through the present. It is questionable whether it can be asserted that the recent start of a drop in U.S. business confidence is completely unrelated to the intermittent episodes of sharp USD appreciation seen since late June. Despite the FRB’s desire to implement an interest rate hike, the path to a hike has been blocked by concerns about the associated trend of USD appreciation (as well as concerns about a global economic slowdown in response to a rise in funding costs). This “USD appreciation trap” situation has been intermittently evident (see exhibit on previous page). There are only two scenarios that will enable an escape from the “USD appreciation trap” – “multiple interest rate hikes by a central bank other than the FRB that create an environment in which FRB rate hikes (or efforts toward a rate hike) do not cause a flood of capital into USD” or “solidly robust conditions in the real economy that are not easily undermined by USD appreciation.” One or the other of these scenarios is required. (The arrows circled in red on the exhibit on the previous page indicate the processes prevented by these scenarios.) Unfortunately, however, neither of those scenarios is likely to take shape during the next 12 months. It seems clear that the strength of conditions in the U.S. economy and global economy are not sufficient to justify predictions of successive interest rate hikes by the FRB and an associated surge of USD appreciation. The U.S. presidential election and forex rates – Limited scope for maintaining the status quo The U.S. president has only two currency policy choices As this article has repeatedly asserted, there is a high likelihood that the currency policy of the next U.S. president – whether it be Hillary Clinton or Donald Trump – will not be accepting of USD appreciation. (In fact, it is probably rare anywhere in the world for a newly inaugurated government to wholeheartedly go along with the appreciation of their country’s currency during the first year of that government.) During the campaign, both candidates have conflated JPY and RMB and repeatedly made factually incorrect, critical statements about the downward guidance of those currencies. Regardless of which candidate wins, it seems likely that the issue of overly weak currencies will become an increasingly hot topic of discussion in forex markets. Of course, it is not wise to expect that all positions presented in the heat of an election campaign will be maintained after the election and, particularly in the case that Clinton (who is widely viewed as being relatively conventional) is elected, many observers are expecting that the maintenance of a status quo with respect to most policies will be conducive to a soft landing. It seems reasonable to expect that, after taking office, the next president will probably shift toward relatively conventional policies. With respect to the forex market, however, it seems that there may be a limit to how much the status quo can simply be maintained. As noted earlier in this article, regardless of whether it was in line with U.S. currency policies or not, it is a fact that the USD appreciation seen during the past two years was extremely rapid, causing USD real effective exchange rates (REERs) to reach high levels. The pace of the USD appreciation from mid-2014 was quite rapid even from a historical perspective. In my view, there have been three major episodes of USD appreciation since 1973, including the current one. Roughly speaking, the first was a seven-year episode from 1978 through 1985, when USD was buoyed by the Carter administrations dollar defense policy and FRB Chair Paul Volcker’s successive interest rate hikes. The second was a seven-year episode from 1995 through 2002, when Treasury Secretary Robert Rubin guided USD upward in line with his “a strong dollar is in the U.S. interest” slogan. (There are alternative methods for defining the months of the episodes’ start and end points, but they do not greatly affect the key related issues.) Looking at REER trends, one finds that REER rose about 30%


during the seven years of the first episode and about 20% during the seven years of the second episode, indicating that there was an average annual rise of roughly three to four percentage points. However, such a pace is quite rapid. The third, or current episode has taken place for about two years since it began in June 2014, and in comparing it to previous episodes, one gets the impression that there remains some leeway for it to continue for a while. REER rose about 15% during the two years, for an average annual rise of about 7.5 percentage points, and this pace has been much faster than in the previous episodes. Going forward, regardless of how long the episode may persist from a long-term perspective, it seems wise to keep alert to the potential for a substantial adjustment (USD depreciation) at some point in time. Since last year, an increasing number of people exposed to my arguments have been asking me whether I am anticipating that JPY appreciation will continue in the subsequent year, but it would be more accurate to say that I am forecasting USD depreciation rather than JPY appreciation. In brief, I have been arguing that there may well be a need for an adjustment to the speed of the USD forex trend seen during the past two years, and I consider JPY appreciation to be a concomitant result of that adjustment. (Naturally, besides the sharp appreciation of USD, I also base my argument on the fact that USD/JPY levels have diverged from their purchasing power parity (PPP) levels. PPP figures have truly been a comforting supplemental factor supporting my JPY appreciation/USD depreciation forecasts since last year.) Returning to the topic of the U.S. presidential election, since the direction of U.S. currency and monetary policies has overwhelming power within the floating exchange rate system, the question of who the next president will be is unquestionably of great importance. However, given that the current situation of excessive USD strength will remain unchanged regardless of who becomes the next president, the next president’s policies simply have a potential for one of three effects; (1) confirming the status quo (USD level), (2) improving the status quo (USD depreciation), or (3) worsening the status quo (USD appreciation). The U.S. economy’s expansionary period has lasted 87 months, making it the fourth longest such expansionary period, and it is said to be approaching an end. In light of this, I do not by any means expect that the U.S. will at this point allow for an interest rate hike and an upward spiraling USD appreciation trend. As the U.S. cannot allow for such trends, I think it more likely that the country will launch additional aggressive measures along the lines of the April 2016 establishment of the “Monitoring List” within the U.S. Treasury Department’s Semiannual Report on International Economic and Exchange Rate Policies. Cannot expect “conventional responses” from FRB Governor Lael Brainard When considering U.S. politics and forex policies, the issue of who will become the next U.S. Treasury Secretary is a high-profile issue on a par with the issue of who will be the next president. There are rumors flying about financial markets that FRB Governor Lael Brainard may be appointed treasury secretary in a Clinton administration, and regardless of whether the rumors are true or not, it seems probable that if Brainard were to become treasury secretary, it would have more than a little influence on the forex outlook. As has been discussed in previous editions of this publication, I have been making considerable reference to Brainard’s speeches in preparing forex rate forecasts since 20144. While the FRB board members and district bank presidents may frequently change their views, Brainard has maintained consistent arguments during the past two years, and the things she has been pointing out are correct in my opinion. While I will refrain from overviewing all her speeches here, it is worth briefly examining her most recent speech, presented on September 12, in which an extremely clear and concise manner explains the issues that have to date led her to maintain cautiously dovish views. Within that speech, she stated that – “Weak foreign growth and the net appreciation of the dollar over the past two years have weighed heavily on net exports, corporate profitability, business investment, and manufacturing production.” – and, in fact, the impact of USD appreciation since mid-2014 has undermined U.S. business confidence while U.S. mining and manufacturing production has decelerated. It is undeniable that this situation has been a background factor impeding progress in the FRB’s very slow-moving efforts to hike interest rates. Compared to the speeches of other high-level FRB officials, each of Brainard speeches makes numerous references to USD forex rates, and the underlying gist of her view on USD forex rates is that, in today’s world, U.S. interest rate hikes would be a self-destructive initiative that would promote USD appreciation against all currencies. Referring to this argument as the “USD appreciation trap,” I have considered it a fundamental concept for use in preparing forex forecasts since last year, and I will probably make similar use of it this year and the next. If central banks other than the FRB become capable of undertaking interest rate hikes (thereby preventing across-the-board USD appreciation), or if the real U.S. economy becomes robust and resilient enough to bear USD appreciation burdens, the “USD appreciation trap” will no longer be a problem, but there is little hope of such eventualities at this time.

4 For more information about FRB Governor Lael Brainard’s recent speeches, please see the September 13, 2016 Market Topic titled “Brainard’s Speech – The pride of the doves.”


In February 2013, when Brainard was Under Secretary of the Treasury for International Affairs, Reuters quoted an anonymous G7-related source as saying that the February 12, 2013 G7 statement had been misinterpreted and that the statement was designed to express concern about excessive movement in JPY exchange rates. JPY showed a sharp surge of appreciation following the report. In light of numerous factors – such as the facts that the comment originated from Washington D.C. and that current Treasury Secretary Jack Lew was then awaiting his congressional confirmation – people began openly speculating that the commenter was Brainard. Given the ideas she has expressed since becoming an FRB board member, there seems to be a high likelihood that she was in fact the commenter in question. In any case, since Brainard has consistently expressed concern about USD appreciation up to now, one gets the impression that it would not be wise to expect “conventional responses” from her if she were to assume the post of U.S. Treasury Secretary. The fact that many forex market participants are now already preparing to brace themselves up defensively to deal with a potential “Treasury Secretary Brainard scenario,” is quite natural when you consider her record. In the case that such a scenario were to be realized, attention would be focused on a “dove triangle” comprising Clinton and Brainard along with FRB Chair Janet Yellen, who has long been considered dovish. There is reason to anticipate that finding opportunities to re-elevate USD/JPY would become increasingly difficult at that time. Risks to my main scenario – Factors promoting JPY appreciation relatively prominent 2016 merely the “first year” of the JPY appreciation/USD depreciation trend This article’s main scenario continues to be that there will be a rewinding of the USD appreciation trend that has progressed since mid-2014, and that the rewinding will be accompanied by a strengthening sharp surge in JPY. In short, rather than JPY appreciation, I am anticipating USD depreciation. There are just three months remaining in 2016 and I will soon begin forecasting the entirety of 2017, but it is worth noting that I consider 2016 to be merely the “first year” of the JPY appreciation/USD depreciation trend and see a high likelihood that 2017 will be characterized by a continuation of 2016 trends. As already explained, although USD has plunged against JPY since the start of this year, it has not fallen so much on a real effective basis. Objectively considered, USD should be considered as remaining too strong to justify expectations that it might show a steady strengthening. Although there is a need to gain a good understanding of the new U.S. president’s currency policies, the U.S. real economy does not have a solid enough foundation to enable growth rates to rise above current levels. (If there were such a solid foundation, it should have already been reflected in the dot charts.) During the next 12 months, I am assuming there is a potential for USD/JPY to descend into the JPY90-95 range. Writing about the sudden surge of expectations of a September FRB interest rate hike in last month’s edition of this article, I wrote – “Regardless of how strongly the FRB desires to normalize its policies, if the country can not put up with the USD appreciation that normalization promotes, then the interest rate hikes will ultimately have to be discontinued.” As expected, the September interest rate hike did not happen, and in my opinion such a hike would be quite difficult to implement during 2016.

Risk Factors Remarks Direction

① FRB monetary policy normaliza on・Successive interest rates hike after unexpectedly high economicgrowth, B/S reductions also affected.

Weak JPY Strong USD

②Potential monetary policy adoptedby new President

・Regardless of new President, Clinton or Trump, Strong USD will beperceptibly capped. Focusing on new Secretary of the Treasurynomination.

Strong JPYWeak USD

③ Additional FRBs easing・Interest rate cut in the wake of U.S. sudden recession & QE4pondering?

Strong JPYWeak USD

④ Risk-taking by Japanese investors・Changing main policy from currency hedges to increasing openpositions?

Weak JPY Strong USD

⑤ Japan officials strong JPY curbing・BOJ's continuous negative interest rates expansion.・Buying USD/JPY intervention (or rumor)

Weak JPY Strong USD

Eur

ope

⑥Commotion over the breakup of theEC intensifies

・Northern Ireland and Scotland seek independence from the UK.Possible concerns about something similar happening overcontinental Europe?

Strong JPY Weak USD

Potential Risks to the Main Scenario

USJa

pan


Amid this situation, I do not think this month’s article needs to make a major change to the forecast scenario but, of course, the scenario is subject to both upside and downside risks. These are presented in the chart on the next page. Fundamentally, there has been no change since last month. I do not believe there has been a change in the whereabouts of risks to the main scenario during the past month. The colored scenarios involve JPY appreciation risks, and the remaining items are JPY depreciation risks. Since the realization of JPY depreciation risks would tend to directly upset this article’s main scenario, it is worth briefly overviewing these JPY depreciation risks. Looking at situations during the past year, what kind of factors could possibly prevent the JPY appreciation/USD depreciation scenario during the year going forward? Overview of JPY depreciation risks – No major concerns Since the main scenario has already incorporated the abortion of the FRB’s policy normalization process, a greater-than-expected strengthening of the U.S. economy enabling the normalization process to proceed smoothly would represent a major forecasting miscalculation. This is shown in the chart as risk factor (1). With U.S. employment reaching a full-employment situation and signs of budding inflation beginning to be confirmed, there does remain some logical justification for the FRB to boost interest rates. The potential scenario of full-scale inflation requiring sharp interest rate hikes in a short period of time is the situation that the FRB would most strongly like to avoid. However, the likelihood of such a scenario cannot be said to be very high. Since interest rates are being progressively eliminated worldwide at this time, a U.S. move to proceed with normalization would inevitably spark a flood of managed funds into USD-denominated assets. The resulting across-the-board appreciation of USD against all currencies would be impossible for the U.S. to cope with politically and economically. This is the “USD appreciation trap” situation that this article has discussed numerous times. As evidenced by the newly established “Monitoring List” of the U.S. Treasury Department’s Semiannual Report on International Economic and Exchange Rate Policies, at least during the forecast period, I do not expect U.S. currency policy (≈political policy) to be permissive of USD appreciation. This situation will be noted again below with respect to risk factor (2). In considering JPY depreciation risks, I think it is better to focus more attention on relatively realistic risks. As this article has repeated each month, the miserable JPY interest rate environment is spurring an acceleration of overseas risk-taking on the parts of Japanese investors, and this (risk factor (4)) has the potential for promoting greater-than-expected JPY depreciation (or preventing the progress of JPY appreciation.) As discussed below, however, given an environment in which U.S. currency and monetary policies will not easily accept USD appreciation, it is questionable whether investors willing to invest JPY while assuming the associated forex risk will become predominant. This article is even considering the possibility that the FRB will reverse its normalization process and head toward additional easing, and it seems that a U.S. interest rate hike this year, and even next year, is an unlikely possibility. Certainly, even though there in fact may be no attractive investments within Japan, it is still hard to imagine a scenario in which JPY depreciation could take root in the absence of an FRB move to hike interest rates. From the supply-demand perspective, some people are inclined to forecast JPY weakening going forward based on expectations of a full-scale resurgence of crude oil prices that decreases Japan’s trade surplus. However, it would be perilous to forecast forex rates based on an assumption that crude oil prices could recover to the high levels they maintained in the past and, even if such an unlikely event were to happen, it still must be remembered that the effect of trade and current account balances on forex rates generally is exerted only after a one year lag. It would be hard to say that there is much of a JPY depreciation risk during the forecast period (the next 12 months). Admittedly, there is always another latent JPY depreciation risk scenario in which the policy responses of the Japanese government and the BOJ (specifically, forex market intervention and additional easing) might elevate USD/JPY (risk factor (5)). While I do not believe that BOJ policies alone are capable of reversing the JPY appreciation trend, if the BOJ policies are perfectly timed to coincide with FOMC displays of hawkishness, then there may be a possibility of a JPY weakening episode that puts USD/JPY (temporarily) outside this article’s forecast range. Regarding forex market intervention, however, as has already been explained, the markets have conceived a strong opinion that the hurdles on the BOJ’s path to additional easing are becoming quite high, and it is hard to imagine what kind of BOJ-led measures would be able to shift the forex scenario to JPY depreciation. Overall, the risk of an unexpected shift to JPY depreciation does not seem very large. Overview of JPY appreciation risks – Greater number of JPY appreciation-promoting factors As I have been repeatedly arguing each month, the possibility that U.S. currency policies will blatantly restrain USD appreciation during the forecast period is undeniable. This is based on consciousness of risk factor (2). Regardless of whether the U.S. economic and financial situations are showing signs of overheating or not, the current period of economic expansion has become among the longest in U.S. macroeconomic history, and there has long been concern about when this period will end. I do not believe the U.S. currency and monetary policies have the leeway for boldly implementing multiple interest rate hikes in this kind of situation, and if this is true, then it is natural to expect the downward adjustment of USD seen over the past two years to continue for the time being. Certainly


Donald Trump and even Hillary Clinton have a history of making hints that they would guide USD downward, and it seems extremely unlikely that U.S. policies would seek to further strengthen USD on a real effective basis. Within the rules of the floating exchange rate system, U.S. monetary policies play the most important role. In his January 2010 State of the Union speech, President Obama announced that his “export doubling plan” called for doubling exports and creating 2 million new jobs over a five-year period. The super-strong JPY scenario that took shape during the subsequent three-year period (2010-2012) is something that should be kept in mind. While concrete examples of such policies are not currently apparent, it is worth keeping a wary eye out for the emergence of similar initiatives. Another JPY appreciation risk worth noting is that the FRB could reverse its normalization process and head toward additional easing (risk factor (3)). The current U.S. economic expansion is the fourth longest in history and could become the third longest during 2017, and the “next move” officially disclosed in FOMC statements is an interest-rate hike. If the U.S. economy matures and its expansion peters out in the not so distant future, however, it has to be presumed that there will be a scenario shift calling for an interest rate reduction rather than a hike. Essentially, while the “U.S. interest-rate-hike guessing game” has been the forex market’s biggest theme during the past three years, one should make sure to keep aware of the risk that the game is becoming outdated. The existence of this risk requires a reexamination of the definition of “normal” that encompasses a reconsideration of the meaning of “normal” in the phrase “normalization process”. In August, John Williams, president of the San Francisco Fed, attracted considerable attention by arguing that there had been a drop in the level of the neutral policy rate (≈potential economic growth rate), and it is noteworthy that decreases in the neutral policy rates of the U.S. and other countries became a theme of discussion at the Jackson Hole Economic Policy Symposium that month. Recently, similar arguments have frequently been heard. In fact, in June 2013, immediately after then-FRB Chair Bernanke promulgated his tapering policy, the assumed neutral level of the policy interest rate was 4.00%, while three years later (June 2016) the level was 3.00%. As the underlying strength of the U.S. economy subsides and the neutral policy rate (the end point of interest-rate hikes) descends, it is important that there be renewed discussion of what should be considered normal. Another significant JPY appreciation risk is that related to Europe (risk factor (6)). Concerns about the capital sufficiency of Germany’s largest bank suddenly surged during September and, during the October-December period, these concerns will coincide with Italy’s constitutional referendum (to be held on December 4). If the referendum proposal were to be rejected and the government of reformist Italian Prime Minister Matteo Renzi were to fall, there would be great potential dangers associated with the subsequent general election, including the possibilities of a strengthening of anti-EU parties and perhaps the organization of a referendum on whether to leave the EU. While it may be standard practice to expect the U.S. presidential election to be the last big event of this year, one should be wary of the possibility that an ambush by the German and Italian crisis could trigger an accelerating general shift to a risk-off mood. Moreover, while the selection of Theresa May as U.K. prime minister appears to have somewhat ameliorated the Brexit crisis, plans call for the formal notification of departure from the EU to be made in early 2017, at which point associated negotiations will start. Because the nature of those negotiations will have considerable import with respect to forecasting future EU-related trends, it will be important to monitor them closely for the emergence of market-moving factors. In addition, key EU countries (the Netherlands, France, and Germany) will be holding important governmental elections during 2017. Since the strength of right-leaning populism is growing in each country, at this time, the holding of national elections in of itself always has the potential for presenting new risk factors. While the above is a comparative overview of risks related to both JPY depreciation and JPY appreciation, one gets the impression that there are a greater number of plausible risk factors that have the potential to strengthen JPY appreciation. In particular, given the state of the United States’ real economy and currency and monetary policies, it appears more realistic to be concerned about the possibility of USD/JPY descending past the 95 and 90 levels than to be concerned about the possibility of USD/JPY ascending past the 110 and 115 levels.


EUR Outlook –EUR’s continued resistance to weakening ECB Monetary Policies Now and Going Forward – The onus will be on the “forthcoming debating area” over which parameters need amendments The onus will be on the “forthcoming debating area” over which parameters need amendments. The September ECB Governing Council meeting decided that the interest rate on the main refinancing operations (MRO), and the interest rates on the marginal lending facility and deposit facility, which are the ceiling and floor of market interest rates, would be kept unchanged at 0.00%, 0.25%, and -0.40%, respectively. This left the gap between the upper and lower interest rates, i.e., the interest rate corridor unchanged at 0.65 pp. This was as per market forecasts. A number of market participants including myself had been expecting an adjustment of the parameters of the expanded Asset Purchase Programme (APP), but these were not decided at the recent meeting. The introductory statement, however, mentioned that “the Governing Council tasked the relevant committees (within the ECB) to evaluate the options that ensure a smooth implementation of our purchase programme.” It seems likely that these committees will relax the various parameters of the APP (the 33% rule, the floor interest rate of assets that can be purchased, maturities that can be purchased, the deadline of the program itself, etc.), to be announced at the next Governing Council meeting scheduled for October 20. As the markets had anticipated an adjustment of the parameters to be announced at the recent meeting, EUR posted a slight increase, but it was an extremely limited response. Looking at the recent staff macroeconomic projections, there seems a very miniscule possibility of the Euro area Harmonised Index of Consumer Prices (HICP) increasing to the neighborhood of 2% by March 2017, which is the present APP deadline. That being the case, it will be necessary to adjust the parameters of the APP to expand the scope of assets that can be purchased under this program in order to enable the extension of the APP beyond March 2017. This much would be as expected. What will be of interest going forward is the “next debating point” after that. Specifically, following the expansion of assets purchasable under the program as a result of the adjustment of the parameters, the question that will come into focus is – to what extent can the current purchase amount of EUR 800 billion a month be expanded. No hints given Almost no hints were given in the introductory statement or ECB President Mario Draghi’s press conference following the Governing Council meeting this time as to what kind of adjustments to the parameters are planned. With less than six months to go before the current APP deadline in March 2017, it was thought that a decision would be taken at least to extend the deadline, but Mr. Draghi said there had been no discussions. Specifically, in response to a question as to whether extending the quantitative easing (QE) program had been discussed, Mr. Draghi said, “We discussed the assessment of the economy and we discussed the broad macroeconomic projections, but we didn't discuss anything else,” apparently cutting off any attempt to search for hints about the adjustment of the parameters. Apart from this, there were also questions regarding the possibility of purchasing shares and bank bonds and the possibility of changing the purchase ratio based on the capital key, all of which Mr. Draghi responded to noncommittally. He limited himself to saying that the committees that had been tasked had “full mandate” to investigate all options. This makes predictions about the next meeting difficult. Mr. Draghi’s remark that the Governing Council would have a discussion about all the issues investigated by the committees, including the politically sensitive issue of changes to the capital key, did stand out. However, it would be rather improper for the ECB, which is a central bank as well as an international organization operating a currency like EUR, to strengthen the purchase amount with a bias favoring specific countries’ government bonds. This option, therefore, does not seem all that practical. Why does the ECB not take action right away? The Real GDP growth rate and inflation rate forecasts in the recently published staff economic projections (see chart on next page) were somewhat downgraded, and it was also emphasized that the risks are on the downside. The Euro area has already had quite a long period of low growth and low inflation, and if we consider that such a situation could easily de-anchor inflation expectations, it is quite understandable that people are beginning to ask why the ECB does not take action right away. In response, Mr. Draghi explained that the Governing Council had decided to maintain the status quo because the ECB staff projections had been downgraded only by a slight margin, and that the inflation rate was expected to improve gradually despite the slight delay compared with original predictions (in other words, the downward revisions were not large enough to warrant an additional easing).


ECB staff outlook （September 2016） (％)

2015 2016 2017 2018

HICP 0.0 0.1～0.3 0.6～1.8 0.8～2.4

（Previous： MAR 2016） (0.1～0.3）（0.6～2.0）（0.7～2.5）

Real GDP 1.9 1.5～1.9 0.7～2.5 0.4～2.8

（Previous： MAR 2016） (1.3～1.9）（0.7～2.7）（0.5～2.9）

Private consumption 1.7 1.7 1.6 1.5Government consumption 1.4 1.7 0.9 1.0Gross fixed capital formation 2.9 3.1 3.3 3.3Exports (goods and services) 6.1 2.6 3.7 4.1Imports (goods and services) 6.1 3.3 4.4 4.7

(Source)ECB (Note) EURUSD is assumed to be 1.11 Year 2016-2018

1.00%1.20%1.40%1.60%1.80%2.00%2.20%2.40%2.60%2.80%3.00%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016（Source）Bloomberg

5yr - 5yr BEI swap forward

However, there is clearly a real problem with regard to the de-anchoring of inflation expectations. In fact, the ECB concluded in a working paper titled “Anchoring of inflation expectations in the Euro area: recent evidence based on survey data” released this August5

that Euro area inflation expectations have been showing signs of a slow-down in recent years. There was, in fact, a sense of caution leading up to the recent Governing Council meeting that the historical slump in the five-year, five-year forward inflation swap (5-year/5-year BEI) would be used as a justification for additional easing. Inflation expectations have slumped to such dangerous levels that it would not be too much to say that they have become an urgent problem for the ECB (see exhibit). Against this backdrop, a reporter asked, “Could you perhaps explain to us a little bit how you read that data, and what signals you take from it? Why it's not more concerning in your view, concerning enough to act?” In response, Mr. Draghi explained that the ECB observed two types of inflation expectations, market-based and non-market-based, and that the latter (a typical example of which is The ECB Survey of Professional Forecasters) has recently been stable (and therefore not of concern). On the other hand, he acknowledged that the 5-year/5-year BEI had been trending down, particularly since Brexit, and that this was in part the result of biased bond transactions. He admitted that there were other reasons too, but they were “harder to explain.” This is an area that is troublesome for the ECB itself, which is precisely the reason why it is thought to have arrived at the reasoning that some kind of action must be taken. This makes one wonder all the more why the ECB did not act right away. In this context, Mr. Draghi remarked that “(inflation) expectations are subject to considerable volatility, and that we have observed even in the past disconnect between the behaviour of these expectations and the behaviour of, for example, oil prices. So (rather than act right away) we are monitoring these developments very closely, and we stand ready to act if we were to detect the signals that there could be second-round effects at play here.” In other words, the ECB would prefer not to act in a confused way based on short-term movements. Not too keen on expanding the margin of negative interest rates? The fate of the negative interest rate policy is also of interest alongside the APP. In this context, there have been an increasing number of remarks by senior ECB officials expressing skepticism about the effects of this policy, and one reporter asked “Is there a sense that (negative) interest rates are now a second-best tool and the QE is a priority?” However, the Euro area credit situation has recently improved both in terms of lending (supply) and borrowing (demand), and market fragmentation, once a concern, is now improving. The negative effects (hoarding of cash, the rise in loan interest rates, etc.) of the negative interest rate policy, which were a cause for concern at the time of the policy’s introduction, therefore, are not being felt. Rather, Mr. Draghi argues that the net interest income of private banks has been by and large stable. Having said that, there is no certainty that this kind of stability can be preserved indefinitely, and Mr. Draghi himself acknowledged that by emphasizing “so far – and I want to stress the so far.” He also admitted that “the current situation of negative interest rates will certainly have consequences and challenges for the (profitability of) banks of which we have to be aware.” In short, even though the possibility of further expanding the margin of negative interest rates has not been ruled out completely, one does get the sense that the ECB is not very keen to pursue that option. As Mr. Draghi himself pointed out, the improvement in the Euro area credit situation is not just due to the negative interest rate policy but probably also due to the second round of targeted long-term refinancing operations (TLTRO2, which is the provision of loans with a negative interest rate). It is not clear exactly what level of impact which non-standard policy measure has had (the September staff macroeconomic projections mentioned that the APP had had an impact of raising the Real GDP by +0.6 pp and the inflation rate by +0.4 pp over the forecasting period).

5 ECB: “Anchoring of inflation expectations in the euro area: recent evidence based on survey data,” Tomasz Łyziak, Maritta Paloviita Task force on low inflation (LIFT), 26 Aug 2016.


0.80.911.11.21.31.41.51.61.7

4.02.00.02.04.06.08.0

10.012.014.0

02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

（Dollar）（% YoY）

（Source）Bloomberg

Euro-zone HICP, M3 & commercial loan

HICP（aggregate） M3Commercial loan EUR/USD（right axes）

1

2

3

4

5

6

7

8

07 08 09 10 11 12 13 14 15 16

（％）

（Source）ECB (Note) Non-financial institutions over 1 year and less than 5 years

Euro-zone loan rate by countryEuro-zone GermanyFrance NetherlandsPortugal Ireland

5 JUN 2014：ECB adopted negative interest rate

21 JAN 2015：ECB introduced APP

At any rate, the highlight of the recent Governing Council meeting was that the Governing Council had tasked a variety of internal committees to look into changing the parameters of the APP, and one gets the idea that this will lead the way to an expansion of the monthly purchase amount of assets in the near future (at the very least, an extension of the program’s deadline is expected). Overview of EUR area credit-, inflation-, and forex-related situations – Continued difficulty of guiding EUR downward Effect of non-standard policy measures on money supply and lending German newspaper reports in late September that Germany’s largest bank had requested assistance from the German government and that Chancellor Angela Merkel had refused caused a sudden strengthening of a risk-avoidance mood for a period of time. Concerns about that bank had increased in January and February of this year, but there have been intermittent flurries of rumors about the management instability of numerous euro area financial institutions other than that particular bank. Particularly worrisome is the upcoming situation in Italy with respect to a constitutional reform referendum to be held in October and an associated banking crisis. This situation appears likely to develop in a way that focuses considerable attention on Europe once again, but trends in the euro area’s money supply and its financial institutions’ lending activities are currently positive. As the graph shows, after such measures were taken as those to introduce negative interest rates and commence purchases of asset-backed securities (ABSs) and covered bonds, the euro area’s money supply (M3) and private-sector lending bottomed out in 2014 and have subsequently been maintaining a trend of increase. Although the acceleration of M3 has recently diminished, the ECB reference figure of +4.5% is continuing to rise, so it appears that the effectiveness of non-standard policies will be positively evaluated from the perspective of currency volume and associated credit trends. Effect of non-standard policy measures on inflation and forex rates However, the effect of non-standard policy measures has not been in line with plans regarding growth in the Harmonised Index of Consumer Prices (HICP), which the ECB has been placing the most emphasis on, or forex rates, which market participants are focused on. As is evident from a glance at the graph on the previous page, HICP growth rates declined beginning from 2012, have remained flat in the vicinity of zero since 2015, and are currently showing no signs at all of rising. (The average mom rate of change in HICP was about 0.0% during the period from January 2015 through July 2016.) In addition, while there had previously been considerable drops in EUR/USD, such drops have not been seen since 2015, and EUR/USD has actually been rising since the end of 2015. It is noteworthy that the public sector purchase programme (PSPP, also referred to as QE) for purchases of government bonds, public sector entity bonds, and agency and supranational bonds was approved in January 2015 and commenced in March 2015, but the anticipated results regarding an HICP growth rate rise and EUR depreciation were not in evidence during 2015. It thus appears likely that the effectiveness of non-standard policies will be not positively evaluated from the perspective of inflation and forex trends. Benefits apparently not commensurate with costs In brief, while it was originally assumed that the effects of non-standard policies would be – (1) non-standard policies (negative interest rates and QE) → (2) M3 (lending) growth → (3) HICP growth → (4) EUR depreciation – it appears that the chain of effects has currently extended to (2) but not to (3) or (4). Moreover, while it seems that the effect of (1) on (2) is apparent, more efforts are needed to confirm that there is actually a causal relationship between the two. In fact, the financial market fragmentation that was problematic during the 2010-2012 period


100

120

140

160

180

200

220

240

07 08 09 10 11 12 13 14 15 16

（JAN 2007=100）

(Source) Bloomberg (Note) Monetary base has been released 8 times a year same as ECB meeting since 2015

Euro-zone base money & money supply（M2）growth

Base money

Money supply（M2）

when European financial crisis tensions were peaking appears to have been resolved by the introduction of non-standard policies. For example, the interest rates on loans in various euro area countries have shown a uniform trend of decline to date (see graph). So it is probably true that the non-standard policies have promoted lending. However, there is little evidence that the policies have generated benefits commensurate with the cost of investment in the policies. Since 2015, the euro area’s base money has grown approximately 70%, but the rise in M2 has been restricted to 8%, suggesting that the currency multiplier is sharply dropping (see graph). This suggests the likelihood that the euro area’s financial system is still somewhat damaged. The combined effects of negative interest rates and PSPP in depressing many euro area bond yields below zero has so far produced only limited benefits – although there has been a rise in lending, the effects have not been sufficient to boost HICP. It should be noted that euro area private-sector lending showed yoy decreases in the 36 consecutive months from May 2012 through April 2015 and, to a certain extent, the trend during the subsequent period of somewhat more than one year appears to be a reaction to the previous decreases. Fruitlessness of sustained efforts to guide EUR downward Regarding EUR exchange rates, it is probably quite significant that, even with the employment of such non-standard policies, the ECB’s sustained efforts to guide EUR downward have not been fruitful. As is repeatedly argued in my book, entitled “Ready for the Japanization of Eurozone, Euro and ECB,” it can be said to be quite natural that the efforts would not be fruitful in light of the fundamental fact that the euro area boasts the world’s largest current account surpluses along with relatively high real interest rates. As the FRB’s normalization process continues to be frustrated going forward, this article’s main scenario anticipates that these fundamentals will gain renewed recognition and will work to sustain EUR exchange rates at robust levels, and is likely that the ECB will be doing its utmost to fight this trend. Given Japan’s experience, however, it appears that, even if it is possible to use monetary policies to slow the pace of EUR appreciation, it will be extremely difficult to bring about a change in the overall trend created by the FRB. In any case, Japan’s experience suggests that the effects of non-standard policies will progressively diminish. When the growth in M3 and lending currently being seen halts, there seems to be a possibility that observers centered on those in Germany will orchestrate increasingly lively discussions of “whether the game is worth the candle”.

Daisuke Karakama Chief Market Economist Forex Division Mizuho Bank, Ltd. Tel: +81-3-3242-7065 [email protected]

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