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Forex Medium-Term Outlook

31 July 2017

Mizuho Bank, Ltd. Forex Department

Medium-term Forex Outlook Mizuho Bank Ltd. 1

【Contents】

Overview of outlook ・・・・・・・・・・・・・・・・・・・・・・・・・・・・P. 2

USD/JPY outlook – “Weak USD and weak JPY” trend may not be sustainable U.S. monetary policies now and going forward – “Weak USD and weak JPY” trend may not be sustainable・・・・・・・・・・・・・・・P. 3

USD/JPY levels – Taking another look at the abnormality of present levels ・・・・・・・・P. 5

U.S. monetary policies now and going forward

– The impact of speculations about Janet Yellen continuing as FRB Chair・・・・・・・・・P. 6

BOJ monetary policies now and going forward – Could the next point of discussion be from a diplomatic point of view? ・・・・・・・・・・P. 8

JPY supply-demand balance – Are there any signs of JPY carry trade?・・・・・・・・・・・・・・・・・・・・・・P. 10 Risks to my main scenario – The resignation of Abe and the “normalization fad” arise as new risks・・・・・・・・・・ P. 11

EUR Outlook – Sintra Sequelae and EUR Appreciation ECB Monetary policies now and going forward – Unsquelchable spark of the Sintra speech ・・・・・・・・・・・・・・・・・・・・P. 14 Supplementary Discussion: Germany’s diplomacy and the euro area economy now and going forward – Renewed emphasis on and dedication to the EU?・・・・・・・・・・・・・・・・・・P. 17


Overview of Outlook In July, with USD depreciating further, this report’s prediction that “USD is too strong when seen from the perspective of its real effective exchange rate and is bound to depreciate” is turning into reality. It is, however, also a fact that JPY has not appreciated as much as USD has depreciated, with a weak USD and weak JPY mood intensifying in the markets over the past one month or so. This is because central banks other than the FRB (mainly the ECB) have begun normalization efforts, and there is speculation that the trend may become established. If this attempt for “monetary policy normalization,” rather than being a transient phenomenon, goes on to become a trend, it could result in a market trend characterized by the depreciation of both USD and JPY, completely overturning the fundamental scenario predicted by this report. However, there are no grounds as of now to believe that the normalization efforts of the ECB or other central banks beside the FRB will become firmly established, resulting in a trend of both USD and JPY weakness as seen during 2006-07. I think the fad will end as just that – a fad. Rather, as far as risk factors go, one must pay more attention to the increasing political instability in Japan (which had so far been praised for its political stability in comparison with the U.S. and Europe), as it could invite a rollback in the JPY selling trend. It cannot be said that the prospects of JPY appreciation in the process of USD strength adjustment have completely faded, so this report’s main scenario remains unchanged from last month. EUR has continued to rise steeply. This is entirely the result of ECB President Mario Draghi’s remark that “deflationary forces have been replaced by reflationary ones” (widely called the “Sintra remark”). Despite retrospective attempts to put out the fire, the momentum of EUR purchase has continued stronger than one would expect. The scaling down of the Asset Purchase Programme (APP) is considered inevitable even simply from a technical point of view, and there is no doubt that some kind of decision will be made on it this autumn. However, it may still take a while for ECB to hike policy rates and to end negative interest rate policy (NIRP). EUR and Euro area interest rates had risen significantly at the time of Draghi’s speech in Sintra, but given the weakness of some of the EU member states, it is unclear whether the ECB’s normalization efforts will really be able to progress smoothly from tapering to rate hikes. Crucially, Euro area inflation is still sluggish, and there will be additional downward pressure on them as a result of EUR appreciation going forward. With inflation being far from target levels, it will not be easy to keep up the normalization chant. Going by the state of affairs in the region, it is quite possible that the ECB, despite being the one to start this “normalization process,” will retreat from the normalization process. This would ultimately result in a waning of the weak USD and weak JPY mood that has recently intensified in the financial market. Summary Table of Forecasts

USD/JPY 108.13 ～ 118.60 107 ～ 114 105 ～ 114 104 ～ 113 102 ～ 112 100 ～ 110

EUR/USD 1.0340 ～ 1.1777 1.14 ～ 1.22 1.14 ～ 1.22 1.15 ～ 1.23 1.14 ～ 1.22 1.13 ～ 1.21

EUR/JPY 114.86 ～ 130.76 126 ～ 135 124 ～ 133 125 ～ 134 121 ～ 130 118 ～ 128

(Notes) 1. Actual results released around 10am TKY time on 31 July 2017. 2. Source by Bloomberg 3. Forecast rates are quarter-end levels

(122)

(1.1741) (1.17) (1.18) (1.19) (1.18) (1.17)

(129.61) (128) (126) (127) (124)

(104)(110.39) (109) (107) (107) (105)

2018 Jul-Sep

2017 Jan-Jul (actual) Aug-Sep Oct-Dec Jan-Mar Apr-Jun

Exchange Rate Trends & Forecasts

70

80

90

100

110

120

130

08/4Q 09/4Q 10/4Q 11/4Q 12/4Q 13/4Q 14/4Q 15/4Q 16/4Q 17/4Q

USD/JPY


85

95

105

115

125

135

145

155

08/4Q 09/4Q 10/4Q 11/4Q 12/4Q 13/4Q 14/4Q 15/4Q 16/4Q 17/4Q

EUR/JPY

1.0

1.1

1.2

1.3

1.4

1.5

1.6

08/4Q 09/4Q 10/4Q 11/4Q 12/4Q 13/4Q 14/4Q 15/4Q 16/4Q 17/4Q

EUR/USD

USD/JPY outlook – “Weak USD and weak JPY” trend may not be sustainable U.S. monetary policies now and going forward – “Weak USD and weak JPY” trend may not be sustainable Will the weak USD and weak JPY trend continue? Looking back at the market trends over the past month, the notable changes were a sharp drop in the USD index by up to -2.5% although it is within the USD weakening trend and at the same time JPY weakened by about -1% against USD. In other words, both USD weakened and JPY weakened. As I have repeatedly said, the main point of my forecasts in this report over the past two years has been that “JPY will appreciate as a side effect of the weakening of USD in the process of the adjustment of its excessive appreciation.” My prediction can be said to have been proved half right (USD weakened) and half wrong (JPY did not strengthen) if we look merely at the past month. Of course, the trend is still young, being not more than a month old, but as it relates to the essential part of this report’s predictions, I would like to present my thoughts on it. Will this weak USD and weak JPY trend really continue? When the US Dollar index falls, JPY tends to strengthen in accordance with it. However, there have been examples in the past when this did not happen. During what became known as the weak-JPY bubble during 2005-07, there was a period from 2006 onward, when the USD index dropped simultaneously with an increase in USD/JPY (see exhibit, top). This was a period when, investors believed that they could make a lot of money by selling JPY and buying foreign currency. In other words, it was the golden age of carry trade (at the same time, this can also be seen as the entry point to the subsequent extremely strong JPY phase). The background to all this was that the policy interest rates for most key currencies were undergoing a series of hikes while JPY alone had a zero percent interest rate (see exhibit, bottom). In those circumstances, it was taken for granted that investing in foreign currency using JPY funds would result in big earnings. Looking beyond USD, there were several currencies that offered even higher interest rates than USD – these included GBP, AUD, and other emerging and resource-rich economies’ currencies. Consequently, it was an age when carry trade was not limited to the purchase of foreign currencies with JPY, there were also many other currencies worth buying in exchange for USD. Both JPY carry trade and USD carry trade were popular, resulting in a trend of simultaneous weakness for both USD and JPY.

70

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130

140

60

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130

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

（Yen）（MAR 1973=100）

（Source）Bloomberg

Dollar index & USD/JPY

Dollar index （left axis） USD/JPY

【2006-2007】USD/JPY moved up despite dollar index declined

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

05 06 07 08 09

（％）


Major countries monetary policy USA

Euro-zone

Japan

UK

Canada

Australia

USA

Japan


Market mood does not seem very conducive to resurgence in JPY carry trade However, as indicated in the exhibit on the next page, USD is the only currency with rising interest rates as of the moment. Recently, policy normalization expectations have strengthened with respect to EUR, GBP, and CAD, but they still remain in the “expectations” zone, and there could be many complications in the process of expectations being translated into reality. With other currencies – EUR, GBP, and CAD – rapidly joining the policy normalization club (which originally included just USD) as a result of strong economic growth, investors may feel attempted to put their money into currencies other than USD. However, if we look back at how difficult the normalization process has been for the FRB, which cautiously began normalization by signaling tapering in May 2013 and has since taken four years to implement half as many rate hikes as originally planned (four times), it In particular, GBP, which soared following the surprising 6-3 votes from the Bank of England Monetary Policy Committee, Contrary to the FRB, the ECB, and the Bank of Canada (BOC), which are attempting to take the normalization path based on the underlying strength of their economies, BOE’s efforts are largely for damage control, as a measure to contain stagflation. What happened in the UK, therefore, is somewhat different from the appreciation of the underlying currency with an expectation for rate hikes. Again, it is clear that Brexit negotiation will be tough over the coming months. The Conservative Party does not appear to have any solid “grand design” for Brexit. Meanwhile, the EU side, led by the European Commission (EC), will not hesitate to make an example of the UK. It is very likely that GBP will weaken going forward, as and when the disadvantageous position of the UK in the negotiations becomes clear – but will the BOE fight back with rate hikes to control inflation? And if the BOE continues to raise rates, will the economy be able to withstand them? In fact, after witnessing the weakening of consumption and investment appetites following rate hikes, the Bank may even have to consider cutting rates. In the case of the ECB and BOC, too, there are quite a few problems that will have to be dealt with in the process of policy normalizing. For instance, the ECB is not considering rate hikes, but rather quantitative easing (QE) tapering, but there is no consensus yet even in terms of whether the program should be scaled down or ended altogether (my view as of now is that it will be scaled down and extended). Given these circumstances, it is important to be aware that the current situation is quite different from that in 2005-07, when the increase in interest rates were taken for granted for several currencies. As mentioned above, in order for the weak USD and weak JPY market trend to continue, there have to be a number of options for the diversification of investments using JPY and USD funds. In other words, it is a question of how much confidence to place in the normalization efforts of the ECB, the BOC, and the BOE. If one can be confident in this connection, it would be worth betting on both the continuing fall of the USD index and a simultaneous weakening of JPY. In such an event, it would be extremely desirable if emerging and resource-rich economies’ also raised their interest rates. I, however, do not feel all that confident in this trend. Market mood conducive to JPY carry trade Many market participants are aware of the strong demand for JPY whenever the risk appetite weakens, so they are likely to be doubtful of any one-sided expansion in the expected earnings gap between JPY and foreign currencies. As we saw above, for a weak USD and weak JPY trend to become firmly established, it is essential for both JPY and USD carry trade to flourish. The conditions necessary for this to happen are (1) a sufficient interest rate gap with multiple foreign currencies, and (2) stable volatility levels. At the moment, condition (2) is being met, but condition (1) remains unfulfilled, with the outlook for its fulfillment being uncertain too. That being the case, one cannot be confident (at least as of now) that the weak USD and weak JPY market pattern seen over the past month will indeed become a trend. Even if a weak-JPY phase driven by JPY carry trade begins, it must be pointed out that eventually, and in theory (i.e., in terms of interest rate parity), it will be offset by future forex rate fluctuations. The exhibit to the right shows the

-0.50.00.51.01.52.02.53.03.54.0

12 13 14 15 16 17

（％）


Major countries monetary policyUSA

Euro-zone

Japan

UK

Canada

Australia

USA

Japan

-30

-20

-10

0

10

20

30

40

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

（％ vs JAN 2005）


JPY carry trade simulation

Income

Capital

Total return

Image as offset by interest rates differential gain and fx exchange loss (strong JPY)


JPY carry trade performance for the 2005-07 period, which was called the weak-JPY bubble, and also for the subsequent period of extreme pessimism following the subprime mortgage crisis and the collapse of Lehman Brothers. It is clear that, for instance, the weak-JPY phase had begun in 2005 and held until 2008 or 2009, interest (income) would have been completely offset by exchange rate capital losses from exchange rate The result was proven by the theory. Of course, if one is confident that one can take profits before the capital loss offsets interest rate income, the carry trade would be successful. However, under the low interest rate environmen, with no prospect for significant interest rate income, continuing to purchase USD/JPY while it is stronger than warranted by purchasing power parity (PPP) involves risks greater than prospective rewards. USD/JPY levels – Taking another look at the abnormality of present levels An outline of milestone rates As I have often said, I consider a continuing selling of the JPY counting on the normalization of the U.S monetary policy since the end of June to be imprudent. Having said that, some are beginning to rethink their forecasts based on this prospective change in monetary policy phase. This may, therefore, be a good opportunity to introduce some possible milestone rates for USD/JPY ahead from the perspective of purchasing power parity (PPP). The chart to the right lists USD/JPY rates for a variety of PPPs, going from a stronger to weaker JPY. The PPPs (Corporate Goods Price Index (CGPI) based, 1973 standard; or the one calculated by the OECD and World Bank) that tend to be quoted relatively more often are in the JPY 95 to 110 range, so I consider this to be the “core PPP zone” and pay close attention to it. If one were to setup milestones in the world of forex rates, where there is no fair value, then perhaps in and around this band would be the best place to do so It is also worth paying attention to the fact that there are no real milestones above the 110 level. Perhaps the most one could do would be to use the corporate price index (CPI)-based PPP, 1973 standard. To be sure, USD/JPY rose to 125.86 at the height of the weak-JPY phase following the introduction of Abenomics, but if USD/JPY begins climbing to this level again, there will not just be resistance from the household sector, but also messages attempting to check JPY weakness from the government sector. Looking at it a different way, the 110-120 range is a vacuum zone from the perspective of PPP, a difficult zone for the rate to become established in, but if merely focusing on the level, the present level definitely seems like a watershed. In this sense, one can say that JPY has been on the weak side (from the PPP point of view) during 2017, given that USD/JPY has been more or less over 110. The upside risk for weak JPY/strong USD is limited When USD/JPY falls below 110 and the trend seems to point to a strengthening of JPY, the markets conspicuously begin to explain the rate level using the PPP, but in fact, forex rate tend to coincide with the PPP level only for the briefest of moments. It is most appropriate, therefore, for forex outlooks to use PPP as the guide when the rates are significantly removed from the PPP, and in an attempt to explain their convergence toward the PPP level. In this connection, I often refer to the history of divergence between the CGPI-based PPP (1973 standard; 97 as of May 2017) and market rates. As the exhibit shows, since the latter half of 1990, USD/JPY market rates often rebounded as soon as the rate of divergence became zero percent. A zero percent divergence rate indicates that the market rate coincides exactly with the CGPI-based PPP, which, therefore, acts as the ceiling.

Reference points of USD/JPY rate

JPY rate Evaluation Standard

58.0 Purchasing Power Parity（export prices,1973 base, May 2017）

74.8 Purchasing Power Parity（export prices,1980 base, May 2017）

75.1 Big Mac Parity(Economist magazine,Jan 2017)

77.3 Purchasing Power Parity（Mid point between export prices and corporate goods prices,1973 base, May 2017）Note 1

90.7 Purchasing Power Parity （ corporate goods prices,1980 base, Apr 2017 ）

96.7 Purchasing Power Parity of materials within manufactured products,etc.(METI,FY2016 survey)

96.7 Purchasing Power Parity （ corporate goods prices,1973 base, May 2017 ）

100.5 Break-even rate for exporters as of Mar 2017 (Cabinet survey, FY2016)

102.0 Purchasing Power Parity （OECD, 2016, GDP base) Note 2

102.8 Purchasing Power Parity （ consumer price,1980 base, May 2017 ）

108.3 Corporate planning rate (BOJ Tankan, Jun 2017 survey, fiscal year)

108.7 Purchasing Power Parity（OECD, 2016, private final consumption）

108.8 Purchasing Power Parity （World bank, 2016)

113.1 Next year ahead forecast rate as of Mar 2017 (Cabinet survey, FY2016)

110.4 31 July 2017

126.0 Purchasing Power Parity（consumer price,1973 base, May 2017）

132.7 Purchasing Power Parity of processing/assembly within manufactured products,etc（METI FY2016 survey）

159.0 Overall Purchasing Power Parity of manufactured products,etc.(METI,FY2016 survey)

260.9 Purchasing Power Parity of energy within manufactured products,etc.(METI,FY2016 survey)

(Source) Made by Daisuke Karakama, Mizuho Bank (Note 1) support level more than 10 years(Note 2) Purchasing power parity (OECD) as of July 2017 （revised every Jun & Dec）

Core

PPP

zone


However, there have been two times over the past forty years when the rates shot through the ceiling. The first time was during the strong-USD phase just before the Plaza Accord, when Reaganomics was the buzzword. The second time was when Abenomics coincided with the start of the FRB’s normalization process (as well as the settling of the European debt crisis, precisely speaking). During both the above phases, one gets the impression that the ceiling was CGPI-based PPP+20%. The present rate level of around 113, therefore, has a divergence rate of over +16% compared with the CGPI-based PPP (JPY 97). USD/JPY could reach the 120 level in the months ahead, but going by past experience it is very difficult to imagine that that level can be sustained. On the other hand, it has historically been relatively common to see CGPI-based PPP -20% or -10% divergence rates. Even at a more gentle divergence rate of -5%, the market rate would be 92. It should be kept in mind, therefore, that considering current USD/JPY rates, the downside risk is greater than the upside risk. Of course, if an inflation rate of +2% becomes the norm, as advocated under Abenomics and its embodiment, the Kuroda-led BOJ, (or if the U.S. economy goes into deflation) the CGPI-based PPP would shift toward a weaker JPY and stronger USD, which would also fundamentally change the present structure characterized by the market rate being excessively higher than the PPP. Given the present state of the Japanese economy, with an extreme shortage of labor, one cannot rule out the possibility of inflation led by wage rise, but from a forex market point of view, what is important is to see whether such an inflation would contribute to a marked shrinking of the U.S.-Japan price gap. Considering that a state of full employment has been reported for quite some time even in the U.S., it is quite likely that the gap will not change that much. USD/JPY is high enough at least in terms of PPP, so my basic understanding is that the upside risk for further appreciation going forward is rather limited. It may be interesting to focus on whatever small upside risk exists, but one must remember that, going by experience, the downside risks that can be forecast are much greater. U.S. monetary policies now and going forward – The impact of speculations about Janet Yellen continuing as FRB Chair USD weakness accelerates following the release of the FOMC statement At the July 25-26 FOMC meeting, the monetary policy was unchanged. Market participants were watching for any change in the statement’s reference to when the balance sheet normalization would begin – the previous statement’s “this year” was changed to “relatively soon,” suggesting that specifics regarding the schedule will be published at the next meeting on September 19 and 20. As of the present time, a consensus seems to be forming around making the decision in September and starting implementation in October. If that happens, it would be quite a swift pace of normalization. However, the USD index dropped sharply around the time of the statement’s release. As Fed acknowledged in the statement that inflation has declined, many market participants are beginning to assume that the pace of balance sheet normalization will be quite slow and rate hikes will also be put off for the time being. Although the October start of balance sheet normalization is much earlier than what I had originally assumed, I would like to predict that its pace will be extremely gentle (“run quietly in the background,” to use Ms. Yellen’s words) and that rate hikes will be put off until next year. Unchanging faith in the Philips Curve Looking at the FOMC statement item by item, the overall assessment was kept unchanged, and the employment and household consumption-related assessments continued to be strong, but the inflation rate was declined. There were already concerns about the weakness of both the aggregate and core personal consumption expenditures (PCE) deflator, so the aforementioned change in assessment is bound to have triggered weakness of USD. In fact, the Core PCE Deflator has clearly dropped its pace from the +1.8% yoy seen early this year (January) to +1.4% yoy in May (see exhibit), so for the FRB to have implemented two rate hikes and more or less finalized balance sheet normalization policies even as such data was becoming available seems very ambitious when seen in light of its price stabilization mandate.

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73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17

(％) USD/JPY PPP rate of divergence （Corporate goods prices, 1973 base）

(Source) Datastream （Note） For real rates to diverge by over 20%from CGP is very rare so it is unlikely to be sustainable

Refer to note


However, as I repeatedly point out in this report, the FRB’s policies at the moment seem to be based mainly on a faith in the Philips Curve. Specifically, the FRB is currently trying to justify “preemptive rate hikes,” based on the theory that prices could soar in a non-linear fashion if the unemployment rate remains below the non-accelerating inflation rate of unemployment (NAIRU) for an extended period of time. Consequently, the Fed’s inflation outlook this time is phrased exactly the same as it was the previous time, and it appears that it has not changed its stance that the slowdown is temporary. Balance sheet normalization is a milder tightening measure than rate hikes The July FOMC meeting was expected to be a non-event, but the forex markets responded relatively strongly. Minneapolis Fed President Neel Kashkari, the only FOMC member to vote against rate hikes at the previous two FOMC meetings, expressed the view that the announcement of the balance sheet normalization itself could trigger tighter monetary conditions and could be viewed as a substitute for a federal funds rate increase, so the first step for the FOMC should be to publish its plan for the balance sheet and watch the market reaction. It could be that market participants also have a similar understanding of the present situation. Start of balance sheet normalization likely to begin in October, but probably difficult to implement balance sheet normalization and interest rate hikes simultaneously as inflation data continue lack-luster – perhaps the recent USD weakness is a leading indicator that this is becoming the dominant market view. Ultimately, this also amounts to the assumption that though the plan to normalize the balance sheet itself substitutes for a rate hike, the pace of the normalization process will have to be restrained amid the uncertain future of the supply and demand of bonds. Contrary to a clear increase in FF rates by 25 bp each time, it is not clear what amount of balance sheet size reduction would be equivalent to what level of rate hikes. This alone is enough to make the FRB move cautiously, so that in the end, the tightening effect is likely to be weaker than in the case of a tightening through rate hikes. The impact of speculations about Ms. Yellen continuing as FRB chair In an interview given to the Wall Street Journal on July 25, President Trump, for the first time, mentioned the process by which the successor to a current FRB chair is chosen. He hinted at the possibility of either Ms. Yellen being reappointed or current National Economic Council (NEC) Director Gary Cohn being chosen to replace her, saying that the decision could be finalized by the end of the year. Regarding Ms. Yellen, Mr. Trump said she “is in the running, absolutely (to be re-nominated). I think she’s done a good job (of preventing USD from appreciating)” “I’d like to see rates stay low. She’s historically been a low-interest-rate person,” clearly encouraging low interest rates and a weak USD. If Ms. Yellen continues in her post, given the President’s clear hint of his preferences, the markets are likely to respond first by purchasing U.S. bonds and selling USD. There are many who think that Ms. Yellen’s sudden haste to normalize ever since her Congressional testimony in February this year was in an effort to accomplish something before the end of her term, and I too have thought that the start of balance sheet reductions may have been intended as a parting gift. If, however, she is to continue, there would be no reason for haste. With the early start of balance sheet normalization adding to speculations about Ms. Yellen’s continuation, market predictions seem to be tending toward a decline in interest rates and a weakening of USD based on the expectation that rate hikes will be shelved for now.

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1

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07 08 09 10 11 12 13 14 15 16 17

（％ YoY）


U.S. inflation rate

Core PCE deflatorPCE target （2％）PCE deflator （aggregate）


BOJ monetary policies now and going forward – Could the next point of discussion be from a diplomatic point of view? Sixth postponement At its Monetary Policy Meeting held on July 19 and 20, the BOJ decided by a majority vote to maintain its monetary policy of applying a short-term policy interest rate of -0.1% and guiding the long-term interest rate to remain at around 0%. Also, in the Outlook for Economic Activity and Prices (Outlook Report) released simultaneously, the forecast for Core CPI (CPI excluding fresh foods) was downgraded, and the deadline for achieving the target 2% inflation rate was postponed to “around fiscal 2019” (from “around fiscal 2018” in the April Outlook Report). Meanwhile, the outlook for the Real GDP was upgraded, as was the overall economic assessment, to “Japan's economy is expanding moderately,” with the outlook for Real GDP growth rate for the years 2017 through 2018 also being upgraded in line with this. Meanwhile, though it no longer seems to draw any attention, this is the sixth postponement of the deadline since April 2013, and will lengthen the time taken to achieve the target to six years. There is neither hide nor hair left of the original short-duration battle plan of two years. Specifically, the Core CPI outlook (median) is now expected to rise to +1.1% yoy during FY 2017, +1.5% yoy in FY 2018, and +1.8% yoy in FY 2019 – a downward revision from the previous time’s +1.4%, +1.7%, and +1.9% yoy, respectively (see chart). Going by the simultaneous upward revision of growth outlook and downward revision of Core CPI outlook, one cannot help wondering what all the fuss over a reflationary policy since April 2013 was about. Cautious wage- and price-setting stance among firms As the Outlook Report also says, “the year-on-year rate of change in the CPI is likely to continue on an uptrend and increase toward 2 percent, mainly on the back of the improvement in the output gap and the rise in medium- to long-term inflation expectations,” so the assumption is that the output gap will shrink going forward, and this will be accompanied by an increase in prices. However, there is a possibility of this logic increasingly losing its sharpness going forward. As widely known, Japan is currently in an unprecedented crisis of labor shortage, so “shortage of demand” is not a phrase that one often hears. Looking at the BOJ’s June Tankan survey, “Employment Conditions” continue to remain in a state of net insufficiency in a number of companies and across all corporate scales. What is more, Large Enterprises have also finally fallen into a state of net insufficiency in terms of “Production Capacity” (see exhibit).

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-5

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5

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25

90 92 94 96 98 00 02 04 06 08 10 12 14 16

（% point）

（Source）Bank of Japan, INDB & Mizuho Bank

Production capacity (All industries)

Large enterprises

Medium-sized enterprises

Small enterprises

Excessive↑↓

Insufficient-60

-40

-20

0

20

40

60

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

（% point）

（Source）INDB

Employment conditions (All industries)

Large enterprises

Medium-sized enterprises

Small enterprises

Excessive↑↓

Insufficient

Major outlook by BOJ policy board members (YoY %)

+1.5～+1.8<+1.8>

+1.4～+1.6<+1.6>

+1.1～+1.5<+1.4>

+1.1～+1.3<+1.3>

+0.7～+0.8<+0.7>

+0.6～+0.7<+0.7>

（Source）Bank of Japan（Note）＜＞ indicate the median estimate by policy board members

Real GDPCPI excluding

fresh foods

FY 2017

Outlook as of Apr

FY 2018

Outlook as of Apr

FY 2019+1.4～+2.5

<+2.3>

Outlook as of Apr+1.4～+2.5

<+2.4>

<+1.8>+0.9～+2.0

<+1.7>

Ex consumptiontax impact

+0.5～+1.3<+1.1>

+0.6～+1.6<+1.4>

+0.8～+1.6<+1.5>

+0.8～+1.9

<+1.9>

+0.9～+2.0


It is difficult to accurately assess where the actual output gap is, but given such extreme labor and capacity shortages, there is no question that the gap is becoming more severe. At the same time, it hints at the logical inevitability of prices rising at some point. Under such circumstances, it becomes easier for people to begin wondering why haven’t prices begun to rise yet, as opposed to the previous complacent assumption that prices would eventually rise. However, the Outlook Report this time repeatedly stresses that there remains a sense of caution in the wage- and price-setting stances of firms, with no indication of a move to improve the terms of trade (Selling Price DI - Cost Price DI) even in the June Tankan. Rather, one senses an inability to transfer the rise in cost price on to selling price, resulting in a deterioration of the earnings environment.

Could the next issue be a diplomatic problem? With regard to the BOJ’s policy operation, the only point that seems to draw any attention anymore is whether the specific mention of the “JPY 80 trillion” target amount for purchases will be deleted from the policy statement, with the markets showing almost no movement following the release of a policy statement or press conference by BOJ Governor Haruhiko Kuroda. However, if we were to go so far as to find something of concern, it would be the fact that the BOJ’s policy operation and its result on JPY rates could become a diplomatic problem. To some extent, it is a fact that under the BOJ’s Qualitative and Quantitative Easing Policy With Yield Curve Control (YCC), the 0% interest rate peg is, in hind sight, a measure to guide JPY weaker, and there were rumors from around the time that the Donald Trump administration began, that it could attract criticism. Thankfully, USD has been steadily weakening since the start of 2017 and the Japanese YCC policy has ended up not attracting much attention, but with the June 27 “victory over deflation” speech by ECB President Mario Draghi, and the monetary tightening mood among American and European central banks (Bank of England, Bank of Canada) from just around this time, there is a clear sense that the BOJ is being left behind. In this midst, USD/JPY rose sharply following the third fixed-rate bond buying operation conducted on July 7, once again creating an atmosphere in which the U.S., depending on how it takes this, could make an issue out of YCC as a policy attempting to guide JPY weaker. Timing-wise, unfortunately, this coincides with a difficult domestic political situation for President Trump amid “Russiagate” speculations, so the situation is conducive to more radical foreign policy moves by the Trump administration. At the First U.S.-China Comprehensive Economic Dialogue, which was held earlier this week on July 19, the two countries could not come to terms with the “more fair” trade relationship that the U.S. seeks, and the meeting ended on a sour note, with neither country giving a press conference following the meeting nor releasing a joint statement. U.S. Secretary of Commerce Wilbur Ross, having criticized China’s trade surplus with the U.S., was reported to have said, “We must create more balance in our trade by increasing exports of made-in-America goods to China,” and China appears to have rejected the suggestion. In advance of the meeting, it was also reported that the U.S. is considering slapping higher tariffs and applying the import quota contingent system against steel exports from China, citing dumping concerns. A rate hike cannot be ruled out if faced with an earnest criticism The kind of friction that happened at the U.S.-China Comprehensive Economic Dialogue is certainly possible in the U.S.-Japan Economic Dialogue too, and should be cause for concern. In particular, given that Japan has a floating exchange rate system unlike China, there is always the possibility of using price, in addition to volume, as a tool for adjusting the Trade Balance. The spearhead could well be aimed at the weak JPY as the direct cause of Japan's enormous trade surplus with the U.S. (the world’s second largest), and at the YCC as its indirect cause. How would the Japanese government and the BOJ react if that happens? A voluntary tightening is essentially unthinkable under the present system, which centers on the concept of working on expectations under an inflation-overshooting commitment. However, an inflation-overshooting commitment is a promise to “continue a policy of expanding the monetary base until inflation has risen above the 2% price stability target,” so, one could interpret it as the commitment being kept so long as the monetary base is expanding. If the U.S. earnestly criticizes the YCC and the government/ruling party decide that the U.S. needs to be conciliated, it is not altogether impossible that the long-term interest rate peg could be raised from the current 0% to 0.2% or 0.3%. I would like to consider the possibility of the BOJ raising its interest-rate guidepost as a risk, because – even though these may not be on the top of Mr. Kuroda’s list of priorities – (1) Japan is currently facing a relatively difficult security situation, and (2) the Abe administration’s approval rating being rather low right now, the government may want to avoid a deterioration of the U.S.-Japan relationship too. Of course, regardless of the circumstances, a rate

-60

-50

-40

-30

-20

-10

0

10

83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17

（% point）

（Source）INDB

Terms of trade (Selling Price DI - Cost Price DI)

ManufacturingNon-manufacturing

Amelioration↑↓

Deterioration


hike is a rate hike, and is a factor that could cause JPY to appreciate, but it is a better alternative compared with JPY appreciating amid rising/protracted tensions between the U.S. and Japan. In the end, if the U.S. dislikes trade deficits, there is no choice but for a trade adjustment to take place, either through volume (import quotas) or through price (forex rates). As the Trump administration continues to face a difficult domestic political situation, it is not altogether improbable that it would take up the YCC for criticism and pressure Japan to make adjustments. JPY supply-demand balance – Are there any signs of JPY carry trade? Supply-demand situation points to net purchase of JPY Going by the JPY supply-demand situation perceived from the Balance of Payments, the momentum of lower JPY still seems lackluster. According to Japan's May Balance of Payments, the Current Account Balance was +JPY 1.6539 trillion, showing a decline in the Current Account surplus for the first time in four months, thanks to the trade deficit. In light of this result, let us take a look at the JPY supply-demand balance (see exhibit) used in this report as a guide when forecasting the JPY outlook – the total supply-demand balance for the January-May 2017 period was a net purchase of JPY worth +1.3049 trillion, which is a complete contrast to the result posted for the same period of the previous year (a net sale of JPY worth -JPY 14.7250 trillion). Foreign securities investment from Japan, which had lacked vigor during the early part of the year, has seen a resurgence since May, but it is not strong enough to swing the basic JPY supply-demand balance toward a net sale of JPY, because the Current Account surplus is quite large in scale. Rather, foreign direct investment is the leading category contributing to lower JPY in the current supply-demand balance – the number of Japanese companies that engaged in M&A overseas during 1H of the current year was reported (in July) to have renewed the record high for the second consecutive year (as per the findings of RECOF Corporation). The first five months of 2017 have gone by, but the fact that the supply-demand balance (used as the basis for my currency forecasts) this year is completely different from the past three years is an important factor. Are there any signs of a resurgence in JPY carry trade? As I mentioned at the start, the current forex rate trend is characterized by both JPY and USD weakness. In such a situation, the important question is whether we will see the reemergence of a weak USD and weak JPY phase similar to 2006-07. Earnings from foreign currency investments were taken for granted during 2006-07, so it was a period of robust JPY as well as USD carry trade (this is what resulted in both USD and JPY weakening). The accounts (asset side; i.e., loans to Japanese customers; same below) of the main Japanese branch of foreign banks are the instrument used for confirming such a trend from the Japanese side. Getting straight to the point, this figure draws attention as something that shows the trend of foreign investors’ procurement of JPY and subsequent investment in foreign currencies. Sure enough, during the weak-JPY phase in 2006-07, the accounts of the main Japanese branch of these banks and the nominal effective exchange rate (NEER) of JPY were correlated (see exhibit). Even though the accounts of the main branches have recovered since the second half of 2016, the recovery is not sufficient to recreate the situation seen during those years. To be safe, let us also take a look at the other side (liabilities side) of the accounts of the main Japanese branches of foreign banks.

-30

-20

-10

0

10

20

30

（Tril yen）

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

Primary supply-demand balance reflected balance of international payments

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

70

75

80

85

90

95

100

105

110

1150

5

10

15

20

25

02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17

（Year 2010=100）（Tril.yen）

（Source）Bank of Japan

Foreign banks' Japanese branch accounts & nominal effective JPY rate

Foreign banks' Japanese branch accounts（asset=loan to home country）Nominal effective JPY rate （right axis）

Weak JPY↑

↓Strong JPY


During 2006-07, we saw a steep rise in procurements on the call market, but no such trend can yet be confirmed this time round. Of course, such a trend is only one of the many pathways to an increase in carry trade, and its absence does not rule out the existence of carry trade. The expansion in the gap between domestic and foreign monetary policies has suddenly become a major topic since late June, but whether or not this will drive JPY weakness alongside USD weakness is still difficult to say, as there is too little information to go by. Looking at the IMM currency futures position as of July 25, 2017, the net position of USD against the eight major currencies has reached a high last seen around four and a half years ago, on February 12, 2013, with the USD index also falling below 95, which was a milestone point during the USD appreciation phase starting June 2014. Will the speculative short position of USD increase to the extent that a declining trend becomes established for the USD index? There are still many hurdles that have to be cleared before one can say that the forex markets have entered a phase similar to the one seen in 2006-07. Risks to my main scenario – The resignation of Abe and the “normalization fad” arise as new risks Prospect of JPY appreciation remains With the end of the month approaching, I would like to assess the risks to my main scenario. In this report, based on my fundamental understanding that “USD is too strong when seen from the perspective of its real effective exchange rate and is bound to depreciate,” I have predicted for the past two years that JPY is likely to appreciate as a consequence of USD’s decline. To begin with the verdict, I do not consider it necessary to change this prediction yet. In fact, since the beginning of this year, the USD index (Intercontinental Exchange) has fallen by almost -9%, which seems to suggest that the adjustment of USD has begun. Meanwhile, JPY has unexpectedly failed to appreciate as much as one would have thought during this phase – one of the reasons for this state of affairs may be the fact that carry trade is being encouraged by the FRB’s stubborn normalization efforts as well as the “normalization fad” seen among other central banks. However, as I have repeatedly said in this report, I believe that the normalization fad among the other central banks is a transient phenomenon that will end as just that – a fad. In fact, the FRB itself may relax the extent of its tightening in the process of shifting its pivot from rate hikes to balance-sheet size reduction. One must also remember that the USD index rose by approximately +30% between June 2014 and January 2017, and as of the present time, the rally has been reversed by not more than a third. Under such circumstances, it is difficult to imagine that the prospects of JPY appreciation in the process of USD strength adjustment have completely disappeared. New risk of Abe resignation? Having said that, there are also risks to my scenario. In the following sections, I would like to take stock of both the upside and downside risks to my main forecast scenario. The chart to the right summarizes the risks, with the colored cells representing JPY appreciation risks while the white cells represent JPY depreciation risks. My understanding that there are a larger number of upside risks continues unchanged from last month. A new risk (7) added to this list this month is the risk of the resignation of Prime Minister Shinzo Abe, and is considered a JPY appreciation risk. Focusing mainly on this risk, I would like to provide a commentary on the main risks. Going by opinion polls, the approval rating for the Abe administration seems to have fallen broadly into the 30-40% range following the significant defeat for the Liberal Democratic Party (LDP) in the Tokyo Metropolitan Assembly elections on July 2, which came on top of the already smoldering school scandal. Some polls even indicate approval ratings in the 20-29% level, which is considered the danger zone. For market participants who have, since November 2012, engaged in transactions based on the intuitive understanding that “the second Abe administration ≈ Abenomix ≈ Kuroda-led BOJ ≈ weak JPY and strong share prices,” Abe’s resignation is likely to be a major event.

Risk Factors Remarks Direction

Wo

rld

① Stability of normalization fad・Normalization is becoming trend, not a fadanymore

Weak JPYStrong　USD

② Economic policy by President Trump・Introduction of HIA. Expanding governmentspending more than market expectation

Weak JPYStrong　USD

③ FRB monetary policy normalization ・Four rate hikes each in 2017 adn 2018Weak JPY

Strong　USD

④Economic (currency) policy byPresident Trump

・Disallowing USD strength, deterringexcessive currency strength

Strong JPYWeak USD

⑤Confusion surrounding suspicions ofRussiagate

・Impeachment of President TrumpStrong JPYWeak USD

⑥ Risk-taking by Japanese investors ・From hedged to open position expansion?Weak JPY

Strong　USD

⑦ Risk of Abe resignation ・Symbolizing the end of reflation policyStrong JPYWeak USD

Euro

pe

⑧ EU related fear・Italy general election (five star movementgovernment take over)

Strong JPYWeak USD

Oth

ers

⑨ Geopolitical risk ・Korean Peninsula emergencyStrong JPY

Weak USD?(Source) Daisuke Karakama, Mizuho Bank

Potential Risks to the Main Scenario

Japa

nU

S


Should Abe resign, it is unlikely that a successor capable of maintaining the current situation conducive to intuitive transactions can be found right away, so many market participants (especially foreign investors) are likely to respond by purchasing JPY. The Kuroda-led BOJ, which is seen as synonymous with the Abe government, could also be forced to make big changes. Of course, as far as candidates who can smoothly replace Mr. Kuroda from the perspective of reflationary expectations go, they are more abundantly available than candidates who can smoothly replace Mr. Abe in this respect (setting aside the question of whether that is a good or bad thing). To put it another way, in the event that Mr. Abe resigns this year or early next year, in order to prevent a resulting dissipation of reflationary expectations, the candidate chosen to be the next BOJ governor is likely to be one who is as strongly dovish as possible. (In this report, my forecasts are based on the assumption that the Abe-Kuroda team will continue to pitch.) The other JPY appreciation risk that remains noteworthy is (4). The dangers of the Trump administration’s currency and trade policies have been pointed out since the beginning, but those risks had receded for a while after the April-March period, when the Syrian and North Korean situations had deteriorated. This change was thought to be in anticipation of China’s cooperation with regard to the North Korean problem, but it has now become clear that China’s cooperation has not had any marked effect, and Mr. Trump’s position is once again becoming more radical. The U.S. and China failed to arrive at a compromise at the first U.S.-China Comprehensive Economic Dialogue held in Washington on July 19. The post-meeting press conference was cancelled and no joint statement was issued, leaving a bad aftertaste. Before the meeting, it was also reported that the U.S. was considering slapping higher tariffs and applying the import quota contingent system against steel exports from China, citing dumping concerns. As of now, no concrete measures against Japan are apparent, but with a second U.S.-Japan Economic Dialogue scheduled to take place before the end of the year, the difficulties surfacing in the U.S.-China economic dialogue cannot be viewed entirely as somebody else’s problem. As I have repeatedly said in past issues of this report, the Trade Balance can only be adjusted in one of two ways – volume, or price (i.e., forex rates). Given that Japan has a more flexible exchange rate system than China, one must assume it possible that Japan will be forced, in the process of negotiations, to strengthen its currency. The “normalization fad” is a JPY depreciation risk On the other hand, as seen during late June through mid-July, an intensifying mood toward normalization among central banks other than the FRB seems to encourage investment funds to be channeled into currencies other than USD. If this happens, both USD and JPY could weaken (risk (1)). As I have already mentioned in this report and in articles written for external publications, I believe that the normalization fad that seems to have caught on following ECB President Mario Draghi’s remarks at Sintra (Portugal) will end as a fad, making it difficult for a weak USD and weak JPY trend, such as that seen during 2006-07, to become established. However, contrary to my assumption, if the economies of not just the U.S. and Europe, but also newly emerging and resource rich economies continue maintaining their strength, and the normalization fad takes root and becomes a trend, then a trend of “both USD and JPY weakness,” which is completely different from this report’s predictions, could become a reality. Other weak JPY risks that are worth noting are (2) and (3), which relate to U.S. economic and monetary policies. In terms of economic policies, the expectations of the Trump administration, which has constantly been attracting attention since it came to power, have already completely faded. Looking at it another way, one must be warned that even a small positive move going forward could trigger a purchase of USD via a rise in interest rates. If expectations regarding economic policies heighten, the outlook for actual economic performance will become more confident, and the FRB’s normalization process will proceed with greater smoothness. As I discussed in yesterday’s issue of this report, I believe that if the FRB begins its balance sheet normalization process in October, it will come to the conclusion that simultaneously implementing rate hikes is difficult at least during the early stages. However, assuming that a major fiscal stimulus package is planned and announced, the FRB, which has been bent on normalizing, is bound to take the opportunity and push rate hikes as best as it can. More so if it becomes clear that current FRB Chair Janet Yellen will not be reappointed. The JPY risk remains on the higher side Apart from the above, in terms of risks related to Europe (risk (8)), there are political risks as well as uncertainties regarding monetary policies. Compared with the political situation in the U.S., the situation in Europe seems more stable – ever since the election of French President Emmanuel Macron, an increasing number of media reports seem to be suggesting that the Merkel-Macron combination will act as an anchor for the EU and lead it slowly toward recovering its stability and development. The tone of these reports itself is worth listening to, but a true sense of security cannot be hoped for before we find out the results of the Italian snap general election scheduled to take place by May 2018. So long as we cannot rule out the possibility of the anti-EU party, The Five-Star Movement, surfacing as the largest party, European politics cannot be ruled out as one of the JPY appreciation risks. Again, the ECB’s normalization efforts have become a major topic in the financial markets since the end of June, and the resultant across the board strengthening of EUR has given rise to a weak-USD and weak-JPY trend,


but it is not clear how long this momentum will last. If the soaring EUR and Euro area interest rates destabilizes the economies of some of the peripheral member states, the ECB will be forced to stop its normalization efforts. If the ECB, which is responsible for having started this worldwide normalization fad, withdraws from the war front, JPY, which has been declining in the midst of the fad, could easily gain momentum and strengthen. Apart from this, depending on how the U.S. handles Syria and North Korea, the risk of JPY purchase gaining momentum as a result of rising geopolitical tensions as in April this year also remains unchanged (risk (9)). I have discussed the various upside as well as downside risks to JPY in the above sections, but there is a sense that the risks suggesting JPY appreciation may be larger in number. In particular, one cannot ignore the risks to Japanese political stability, which newly surfaced early this month. Given that political stability was the one thing thought to be Japan's strength when compared with the U.S. and Europe, investors who have been selling JPY and purchasing Japanese equity may find themselves particularly shaken. Meanwhile, the weak JPY and weak USD trend, which has been continuing since the end of June amid the sudden normalization fad, seems to have lost steam toward the end of July – it seems rather unlikely, therefore, that it will become established as a trend. However, if a structure of the BOJ being the only major central bank to follow a monetary relaxation path becomes established during the current forecasting period, JPY could weaken more than predicted by this report, despite USD also weakening. For this report, which predicts JPY appreciation, this is one of the biggest risks to watch out for.


EUR Outlook – Sintra Sequelae and EUR Appreciation ECB monetary policies now and going forward – Unsquelchable spark of the Sintra speech Unsquelchable spark of the Sintra speech Following the July ECB Governing Council meeting, the key ECB interest rates, i.e., the interest rates on the main refinancing operations (MROs) were kept unchanged at 0.00%, with the interest rates on the marginal lending facility and deposit facility, which are the ceiling and floor of market interest rates, also remaining unchanged at 0.25% and -0.40%, respectively. As a result, the interest rate corridor (the difference between the ceiling and the floor) also remained unchanged at 0.65 pp. While it had previously been assumed that the asset purchase programme (APP) might be shrunk in stages (tapering), there was no indication that such tapering was discussed, and the ECB kept the phrase hint that the APP might can be extended if necessary in the introductory statement. The retention of the hint is in line with this report’s expectations, but the lack of discussion of tapering was surprising. This seems to reflect the surprise of Governing Council members regarding the considerable rises in interest rates and EUR stemming from President Draghi’s June 27 speech (presented in the Portugese town of Sintra, the speech is frequently referred to as the ‘Sintra speech’), in which he stated that – “Deflationary forces have been replaced by reflationary ones.” It appears that all the Governing Council members (including Bundesbank President Jens Weidmann) unanimously approved of the Introductory statement’s text, and one gets the impression that it was decided that, first of all, it would be wise for the ECB to put a brake on the trends stemming from the speech. Despite such ECB related speculation, however, both euro area interest rates and EUR have been rising since the Governing Council meeting. As Draghi explained at the post-meeting press conference, the ECB is planning to consider tapering this autumn, so there should be no change at this point to market participants’ main forecast scenarios. It seems likely that the normalization expectations sparked by the Sintra speech will not be easily squelched unless there were to emerge obvious signs of deterioration in economic and financial situations. From January 2018, the shrinking of the APP will make euro area interest rates more susceptible to upward pressures. This is a reason for a rise in EUR buying, which is an extremely natural development. As this report has repeatedly argued, however, given that the prospective levels of the euro area’s Harmonised Index of Consumer Prices (HICP) are already low and that EUR appreciation is increasingly likely to further reduce those levels1, there are risks associated with continuing a protracted process of announcing monetary policy normalization measures. While one gets the impression that the FRB has partly through hard work been able to surmount the challenge of USD appreciation, it is questionable whether the ECB, which has weak countries in its area, would be able to surmount its challenges by means of similar measures. I am anticipating that, even if the ECB decides on and begins implementing tapering, it will still be extremely difficult for it to actually go so far as to hike interest policy rates. “Autumn” discussions – When? What topics? In response to the first question at the press conference asking for tapering-related details, President Draghi said – “We were unanimous in communicating no change to the forward guidance; and also we were unanimous in setting no precise date for when to discuss changes in the future.” Immediately afterward, however, he said – “we simply said that our discussions should take place in the fall” – and this ultimately contributed to a continuation of the hawkish mood. Similarly, in response to the subsequent question – “Have you asked ECB staff to start looking into the technical options for QE beyond December, just at a technical level?” – Draghi said that such instructions have not been issued. In short, the situation at this point is that, neither have the staff been given any instructions, nor has the Governing Council undertaken any discussions. However, it bears repeating that, from the markets’ perspective, the fact that “discussions will take place in the fall” is important, and it is this fact that has easily spurred uptrends in euro area interest rates and in EUR. So what is the precise meaning of the reference to “the fall”? In this regard, near the end of the press conference the question – “does 7 September count as the fall, the autumn?” – was posed, and Draghi admitted that 7 September was within the scope of autumn. The same questioner asked the question – “What kind of new information would you need to see between now and the fall to convince the ECB that something needed to be adjusted in terms of the stimulus?” – and Draghi noted that there would be a benefit in having the latest staff macroeconomic projections available. In light of this, it seems reasonable to anticipate that the September Governing Council meeting will at least issue instructions to the ECB’s technical staff. There will be three key events in September – the ECB Governing Council meeting on the 7th, the FRB FOMC meeting on the 20th, and the German legislative elections on the 24th. Because the FOMC meeting is expected to make a decision on balance sheet shrinkage, it seems likely that the Governing Council will avoid making a major decision of its own immediately before that. Therefore, it seems safe to anticipate that the September Governing Council meeting may 1 Please refer to the July 5, 2017, issue of Mizuho Market Topic entitled “Current and prospective situations regarding an ECB-style taper tantrum”.


issue instructions to the technical staff with a view to the possibility of making a decision on tapering at the October 26 Governing Council meeting. In this regard, a reporter inquired about the time sequence of discussions, asking – “You said you haven’t asked the committees yet to prepare options for an exit. What are the chances that are your next [September] policy meeting you actually have concrete options on the table that you could discuss and take a decision on? Or would you only task committees to prepare options after your initial discussions on a possible exit in the autumn?” Realistically, it does not appear very likely that the September Governing Council meeting will make a quick decision about any major policy issue. Essentially, the market expectations on any signals for QE tapering have not changed at the July meeting but the market participants will again focus on any details of tapering discussion at the next ECB meeting. Timing of the announcement of QE tapering discussion is not a major issue with regard to the progress of appreciation of EUR predicated on expectations of normalization. The speeches to be presented at the Jackson Hole symposium on August 24-26 have already been prepared, and it seems likely that it has been decided that, although July has been passed by based on a wait-and-see strategy, there subsequently will be ample opportunities to smooth the way toward a decision in October. Regarding “topics to be discussed in the autumn,” one reporter at the press conference asked the question – “[...] in some parts of the market there have been demands that it perhaps would be wise and sensible that the ECB would put forward a kind of road map, a kind of timetable, concerning, of course, tapering, but also concerning possible changes in general monetary policy. Would you say that something like this would be helpful?” In response, Draghi said – “[...] this is exactly what is going to be the substance of our discussion in the fall.” While one cannot be sure about what the September discussions will boil down to, it does seem fairly certain that the prospective schedule for dealing with the APP will become clear during the September-October period. Likelihood that the possibility of further easing will be maintained going forward Regarding the ECB’s normalization process going forward, there is concern about how much negative impact the rise in Euro area interest rates and EUR following the Sintra speech might have on that process. On this point, however, Draghi’s statement that – “There was a general reiteration of the point that convergence of the inflation to our objectives remains conditional upon the very substantial monetary accommodation that is now in place.” – suggests that ECB not to expect a sudden tightening of the financial conditions. Concrete examples of this include the progressive tightening of corporate bond spreads, the fact that euro area 10-year interest rates on a GDP-weighted average basis are at the same level as they were at the start of the year, the fact that bank lending rates have continued to be at extremely low levels, and the fact that bank lending surveys indicate that lending standards have been further easing. That said, only a month has passed since the Sintra speech, so any negative impact it might have had would not yet be apparent. It will be worth monitoring how much tightening of financial conditions may emerge with a one-to-two-quarter time lag on the somewhat shaky economies of peripheral euro area countries. In addition, there was a question posed at the press conference asking whether the Governing Council, in the case that it actually begins communicating about its tapering plans, would be concerned about a market tantrum similar to that seen following the FRB’s 2013 tapering announcement. Draghi refrained from commenting on market reactions and explained that the “bottom line” of the Governing Council discussion was that – “inflation is not where we want it to be, and where it should be.” He emphasized that this is precisely the reason why the ECB has reiterated the forward guidance with the possibility of further easing and, focusing exclusively on that portion of his statements, one is forced to wonder whether tapering will in fact be implemented or not. However, even when tapering is actually being implemented, there is nothing particularly peculiar about hinting at the possibility of further easing if ECB sees an unwanted tightening of the financial conditions, and it seems likely that the – “If the outlook becomes less favorable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.” – text will be retained going forward. It seems most likely that, fearing the possibility of an unintended tightening of the financial environment, the Governing Council will have a policy of continuing to hint at the possibility of APP extension as it carefully progresses with regard to winding the size of APP down. Sintra Sequelae One gets the impression that the ECB has somewhat stepped back after witnessing the Sintra speech’s power. However, as can be understood from the market movements following the most recent Governing Council meeting, it is now becoming difficult for the ECB to undertake policy course adjustments based on verbal guidance alone. This was reflected in a portion of a question posed at the press conference – “In Sintra my impression was that you seemed quite confident that reflationary pressures were starting to re-emerge and that the weakness in inflation would be temporary. Today you’re saying that you see no sign of a pickup in headline inflation.” – by means of which the reporter was casting doubt on how the ECB had changed its tune following the Sintra speech. Essentially, the speech is perceived as having high-handedly sparked irreversible expectations of hawkishness, and it appears that, going forward, the ECB will be forced to undertake policy management while struggling with the speech’s sequelae. Despite Draghi’s denials, it is clear that the markets are deeply uneasy about a tantrum. In fact, the


reporter casting doubt on how the ECB had changed its tune went on to ask– “[in the case of a market tantrum] would you consider doing something similar to the Bank of Japan, where there is an attempt to manage the yield curve quite carefully and directly?” In response to the question, Draghi first presented a detailed explanation of the Governing Council’s sense of discussion regarding the assessment of economic conditions, then denied that he had changed his tune from that of the Sintra speech. While a key sentence of the speech was – “The threat of deflation is gone and reflationary forces are at play.” – Draghi argued that the definition of ‘reflation’ is – “when the price level has fallen below the trend line and it recovers. It recovers from below the trend line: that’s the technical definition of reflation.” He then argued that, based on this definition, the Sintra speech assertion that “the threat of deflation is gone” is not significantly different from the Governing Council’s current fundamental view that “inflation rates are still far from our inflation aim,” and it is probably true that one cannot accurately say that Draghi has changed his tune during the past month. This explanation makes sense, but there are very few market participants who take the trouble to precisely clarify word definitions before taking action. It seems clear that the import of Draghi’s Sintra speech was that “euro area inflation rates have bottomed out,” but if this is true, then it would have been better for him to have said so with greater clarity. As reflected in a question posed by one reporter – “Would you say that there has been perhaps in parts of the economic and financial world a kind of misinterpretation of what you have said in Sintra?” – it is impossible not to get the impression that an interpretation quite different in nuance from the Sintra speech’s intended meaning has become quite pervasive. (Draghi concisely dismissed that question, saying – “I never, ever comment on market developments.”) Although the July Governing Council meeting dodged the issue, given the sharp surges in interest rates and EUR, it seems likely that the market reaction to the September meeting will be of a quite large magnitude, but the really important issue is how well the euro area’s peripheral countries would be able to cope if they are faced with an unintentionally created tightening environment. It seems that the markets are continuing to neglect the related problems. EUR appreciation hindering normalization As argued in a previous edition of Mizuho Market Topic2, EUR appreciation is likely to be presenting the ECB with challenges going forward. This is already happening insofar as, even without actually undertaking normalization, the ECB has by merely hinting at normalization spurred rises in interest rates and EUR. Although this may be in line with Germany’s plans and expectations, it seems likely that it will seem overly hasty from the perspective of Italy. Moreover, given that French President Emmanuel Macron has presented himself as a liberal, it remains to be seen how much scope public opinion within France will allow him to follow Germany’s lead regarding fiscal and monetary policies. Although the top leaders of France and Germany may have an increasingly good rapport, there has not been a convergence between the two countries’ levels of fundamental economic strength and, based on statements by French policy makers in the past, one gets the impression that there will be a limit to how much EUR appreciation they will tolerate. As EUR/USD has surpassed the landmark 1.15 level, the difficulty of managing euro area with diverse countries appears likely to become increasingly apparent. Moreover, the pressure for lower inflation as a reault of EUR appreciation will clearly be another hurdle on the path to normalization. The assumed EUR/USD rate of the ECB’s latest staff forecast is 1.08, and a rate of 1.15 represents an approximately 6.5% rise over that assumed rate. Based on ECB calculation methods used in the past, 1% of EUR appreciation is expected to suppress HICP by 0.05 percentage points after a lag of four quarters. Thus, if the current EUR exchange rates were to remain unchanged, the EUR appreciation effect alone would be expected to depress the September 2016 ECB staff forecast’s 2018 HICP levels by 0.3 percentage point. (Specifically, assuming no change in other factors, the HICP rate would be revised downward from +1.7% to +1.4%.) As of yesterday, the deviation from the long-term average level of EUR’s nominal effective exchange rate (NEER) had shrunk to about -1.5% and, while negative EUR NEER deviation has been sustained since 2014, the recent trend appears likely to eliminate this deviation (see graph). A 1.5% increase from the USD/EUR EUR/USD rate of 1.15 brings the rate into the 1.17-1.18 range, and that is roughly the range it was in during the last week of July.

2 Please refer to the July 5, 2017, issue of Mizuho Market Topic entitled “Current and prospective situations regarding an ECB-style taper tantrum”.

1

1.05

1.1

1.15

1.2

1.25

1.3

1.35

1.4

85

90

95

100

105

110

115

11 12 13 14 15 16

（Q1 1999=100） EUR/USD NEER

NEERLong term average (NEER)EUR/USD（right axis）

（Source）Bloomberg （Notes）EU 19 countriesvs.G20 countries base. Boild line: Q1 1999=100

Up↑

EUR rate↓

Down


However, this rate is more than 10% higher than the assumed rate in the June staff forecast, so it would be expected to depress HICP by 0.5 percentage point. Accordingly, depending on movements in crude oil prices, it would appear that HICP has the potential for falling well below the +1.0 level. If this were to happen, the ECB would be far from being positioned to undertake normalization. There are numerous factors that may impede the normalization process – including Italy’s general election, Brexit negotiations, the Trump administration’s trade policies, and the current and prospective situations of China and other emerging countries – but it appears that the factor most realistically likely to impede the process is the EUR appreciation trend of the ECB’s own making and the effect of that trend in depressing inflation. Supplementary Discussion: Germany’s diplomacy and the euro area economy now and going forward – Renewed emphasis on and dedication to the EU? U.S.-German relations and Germany’s diplomatic policies Despite the confusion of U.S. domestic politics and the country’s (voluntary) efforts to isolate itself diplomatically, steady progress is being made by other countries in the building of new frameworks on the diplomatic stage. Last week, this progress could clearly be seen in the increasingly close ties between Germany and China, which attracted widespread attention. Since she declared – “The times in which we could completely depend on others are, to a certain extent, over. I’ve experienced that in the last few days.” – following the Taormina G7 event at the end of May, German Chancellor Angela Merkel has decisively moved to distance Germany from the U.S., and the initiative to build closer ties with China can be seen as an extension of this. On July 5 – just before the G20 summit conference in Hamburg, Germany (July 7-8) – Chinese President Xi Jinping met with Merkel in Berlin, said that China supports Germany’s position within the G20 to promote free trade and prevent global warming. It goes without saying that the statements were indirect critiques of President Trump, who is conspicuously uninterested in the goals of free trade promotion and global warming prevention. At a press conference prior to the Germany-China summit meeting, Merkel expressed her positive expectations regarding Germany’s relations with China, telling Xi that – “I am delighted to be able to welcome you in a period of unrest in the world, where China and Germany can make an effort to soothe this unrest a bit and to make a somewhat quieter world out of it.” Xi responded by saying that – “Chinese-German relations have entered a new phase.” – and the ‘new phase’ phrase has become the standard descriptor of the two countries’ increasing closeness. Of course, China is for its own sake seeking to promote participation in its Belt and Road Initiative from as many countries as possible, and it succeeded in getting German support for the concept, as Merkel said that Germany can contribute to the initiative’s realization. In this and other ways, Germany’s movement away from the U.S. and toward closer ties with China has been becoming increasingly obvious during a period somewhat longer than a month. Since the end of World War II, Germany’s diplomatic policies have been founded on the two main principles of (1) ‘deepening European integration’ through measures including those to conciliate France and (2) the pursuit of ‘Atlanticism’3 policies focused primarily on cooperation with the U.S. Owing to Mr. Trump’s election as the president of the U.S., the second principle has become shaky while the first principle has increased in relative importance, and it seems likely that Germany’s increasingly close ties with China to a great extent reflect a desire to supplement the Atlanticism. Germany is making use of the opportunities to build new alliances presented by such venues as G20 meetings. Postwar German Diplomatic Policies However, it would be superficial and incorrect to consider Germany’s pursuit of closer ties with China as a courtship of fellow anti-protectionist, anti-American countries. China is still a beginner regarding free trade promotion, and it does not have the kind of floating exchange rate system required for a full transition to capitalism. Regarding democracy and human rights protection, also, China does not seem to be a partner that shares Merkel’s set of values. Just as China has a self-serving interest in promoting its Belt and Road Initiative, Germany is building closer ties with China while anticipating that the ties will bring considerable economic benefits. According to the Federal Statistical Office of Germany, China was Germany’s top trade partner (exports + imports) in 2016, while the U.S. fell from being Germany’s top trade partner in 2015 to being the country’s third-ranked trade partner in 2016. (France maintained its position as Germany’s second-ranked trade partner.) From Germany’s perspective, the UK’s departure from the EU raises the possibility that Germany may face a major scenario change as it becomes increasingly distanced from both the UK and the U.S. While a chilling of two countries’ political ties does not necessarily entail a resetting of the countries’ economic and financial relations, the extremely large presence of the foreign sector in Germany’s economy probably makes it inevitable that the country will be particularly sensitive to

3 “Atlanticism” generally calls for policies based on political, economic, and military cooperation with North America (the U.S. and Canada).


changes in international political situations. It seems likely that Germany is calculating that if it does not consolidate its ties with China, its economy may well subsequently suffer growing damage from the deterioration of its ties with the UK and the U.S. Of Germany’s total exports in 2016, 8.9% went to the U.S. and 7.1% to the UK, for a total of 16%, while only 6.9% went to China (including Hong Kong, same below). While the UK and China are currently German export markets of roughly equal size, going forward, given the possibility that the UK’s exit from the EU may be accompanied by the repeal of common tariffs, it seems quite likely that China will come to absorb relatively more of Germany’s exports. It appears inevitable that Germany will focus a greater share of its economic diplomacy efforts on China. As the graph shows, over the past decade, the growth in German exports to China has been more dynamic than that in German exports to the U.S. and the UK. Renewed emphasis on and dedication to the EU? However, it goes without saying that Germany should be giving top emphasis to its first diplomatic principle of deepening European integration. While it is true that the U.S. is becoming increasingly isolated, it is also true that the dogmatic adherence to economic principles Germany has demonstrated to date seems almost certain to bring about its isolation within the EU. While one might get the impression that Germany would merely be passively reacting by giving greater priority to the EU in response to the shakiness of Atlanticism brought about by the U.S. and the UK, the current situation is actually an excellent opportunity for Germany to begin proactively considering the kind of expansionary fiscal policies, Euro bonds, and other intraregional fiscal transfer that it has previously disdained. If Germany does that, it will be beneficial for the future of the EU. While intraregional fiscal policies have been a strongly tabooed subject within Germany, Germany also has a need to consolidate its foothold in the EU, and it should be recognized that the time has come for considering different approaches to that task. Given that Merkel has had to overcome difficult refugee-related challenges and yet seems almost assured of winning a fourth term as chancellor, one would think that she is equipped with the political resources required to address the taboo of intraregional fiscal transfers. At a time when Germany has developed a “peculiar economy” in that all its domestic economic sectors (household, corporate, government) are recording net savings surpluses, it would not be theoretically incorrect for the government sector to accelerate its consumption and investment activities. Speaking of expansionary fiscal policies, it seems likely that the scale of Germany’s defense budget will become an issue attracting increasing attention going forward. At the NATO summit just before the Taormina G7 meeting, President Trump criticized EU countries for not allocating defense budgets in line with their NATO commitments, and this issue is said to be one of the factors contributing to the current U.S.-Germany frictions. Specifically, Mr. Trump has expressed his dissatisfaction with the fact that many NATO countries have failed to live up to an agreement reached at a NATO summit meeting held in Wales in 2014, which calls for them to boost defense spending to a level corresponding to 2% of GDP. With defense spending of only about 1.2% of GDP, Germany is among the countries that have not complied with the agreement but, in the wake of frequent terrorist attacks, Russia’s annexation of the Crimea, and other events, it has been reported that Chancellor Merkel is adopting a positive stance regarding defense budget expansion. However, Germany’s expansion of its defense capabilities will inevitably spur unease within the EU, and this may well impede progress regarding Germany’s key diplomatic principle of deepening European integration. Ultimately, moving ahead with the planning and implementation of expansionary fiscal policies positioned as initiatives that benefit the great and just cause of promoting the EU’s dynamic prosperity is the ideal choice for the sake of both Germany and the EU. In this sense, it is hoped that plans for the full-scale consideration of euro bonds will be realized in the near future. It will be a blessing in disguise if the shakiness of Atlanticism spurs Germany to make the right choice in renewing its identity as a key EU member positioned to generate benefits throughout the EU.

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

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

Q12007

Q42007

Q32008

Q22009

Q12010

Q42010

Q32011

Q22012

Q12013

Q42013

Q32014

Q22015

Q12016

Q42016

（％)

（Source）Datastream

Germany's exports ratios

USA China+HK UK


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