- 2017 has not been kind to USD/JPY, with most rallies quickly running out of steam
- Given recent dollar strength and some progress on North Korea, there are reasons to be optimistic
- The upcoming elections will remain a headwind, but USD/JPY can rally from here
USD/JPY has been in a bear market for most of 2017, and short-term gains in the pair have been mostly fleeting. The currency pair has suffered both from a dollar bear market that has endured for most of 2017 and due to increasing political risks in the Korean Peninsula. While both factors remain in the background, the picture for USD/JPY is finally brightening given rising optimism towards the dollar and indications that a diplomatic resolution may resolve North Korean tensions.
The dollar: another rate hike + tax cuts
We previously warned that sentiment towards the dollar was approaching bearish extremes, and that the bar for positive surprises was extremely low. Despite expectations of a Reagan-style tax overhaul, even a limited improvement to the US’s current tax regime would be dollar-positive. While Trump’s tax proposal was far from complete (as we anticipated in our preview), progress towards tax reform has markets excited. With the rising possibility of corporate tax cuts and US dollar profits returning home from overseas, the dollar has been strengthening.
Looking at monetary policy, both Federal Reserve Chair Yellen and voting member Harker have called for another interest rate hike in 2017 in recent days. Expectations have risen accordingly, and interest-rate sensitive assets such as the yen have sold off.
While it remains too early to call a ‘dollar bottom’, at the very least, the cycle of continuous pessimism towards the currency has now been broken. Whether or not the dollar enjoys a small rebound or a larger move up remains to be seen.
North Korea: good progress, but more is needed
On the geopolitical side, the yen remains highly sensitive to provocations from North Korea. This year has seen a rise in risks from the Korean Peninsula, given that North Korea has conducted more nuclear tests and flown rockets above Japanese soil. Similar to previous administrations, Trump initially called upon China to take a more active role in reigning in its troublesome ally. While the country initially resisted, it has recently taken a series of big steps to make life more difficult for North Korea.
Specifically, China has banned its banking institutions from doing business with North Korea and has also ordered the closure of all North Korean businesses inside the country. In line with recent UN sanctions, China has also restricted crude oil sales to North Korea.
While progress in the past few weeks has been promising, the issue remains far from resolved. If rumored negotiations taking place in Switzerland yield fruit, then the yen has room to fall significantly from here.
Japan: a changing political landscape?
The last factor holding back USD/JPY is the country’s political landscape. As we covered in a previous article, Japanese politics have had a limited influence on the currency in recent history. Yet, the stunning rise of Yuriko Koike has energized the Japanese opposition. Today, Abe remains the clear favorite to win the upcoming elections, based on recent polling data showing his party would win by a landslide. However, markets can’t fully discount Koike as her party crushed Abe’s LDP party in Tokyo regional elections earlier this year. Thus USD/JPY is likely to remain subdued until the political outcome of the elections on October 22 is clearer.
All in all, the picture looks rosy for USD/JPY despite near-term headwinds. Following the upcoming elections on October 22, USD/JPY should have no problem gaining beyond 115 if current trends persist. A recent overview of USD/JPY trading history in 2017 is shown below:
Will USD/JPY be able hold above 114 in the future?