As expectations for tax cuts rise this week, the yen is taking the news in stride. Previously, we had argued that the yen was set to weaken given strength in crude oil and potential US tax cuts. In an environment where GDP growth is strengthening, an upturn in inflation expectations usually leads to a stronger US dollar (as markets price in additional rate hikes). As both rising crude oil and tax cuts raise inflation expectations, our view was that the yen should fall in relative terms. An overview of USD/JPY is shown below for reference:

Weak trend, and not much momentum

Source: TradingView.com, MarketsNow

The last time the yen sold off sharply was following Trump’s victory in the US presidential elections (stronger USD/JPY implies yen weakness). At the time, US growth and inflation expectations shot up as markets priced in Donald Trump’s pro-growth agenda coupled with a Republican sweep of both houses of Congress.

Recent events fail to excite the yen

This time, reactions in the yen have been fairly modest. The yen began weakening in October after the US Senate passed the 2018 government budget (allowing tax reforms to pass without a Democrat filibuster). As hopes for tax reforms rose and crude oil kept rallying, the yen seemed destined to keep weakening.

In November, the yen strengthened following developments in Special Counsel Robert Mueller’s investigations. According to news reports, his investigations suggested that Trump had colluded with the Russian government as a candidate – an impeachable offense. While fears of ‘Russia-gate’ have since proven unfounded, tax reforms have become far more likely to get through Congress. Despite better political news from Washington, the yen has only modestly weakened. The ongoing rally in crude oil has also had a limited impact on the currency. While WTI crude has strengthened to $59 per barrel, markets have discounted today’s high crude oil prices as transitory in nature. As the current bearish trend in the yen runs out of steam, the odds of a significant sell-off from here seem remote.

Bank of Japan sounds surprisingly hawkish

In comments delivered earlier today, Bank of Japan Governor Haruhiko Kuroda delivered a remarkably strong warning regarding the risks of quantitative easing. According to Reuters, Kuroda said that the next step for the Bank would be to withdraw (not increase) the current monetary stimulus program. He also said that changes in the country’s economy could lead to higher bond yield targets. For the first time, he acknowledged the fact that the Bank’s policies have an adverse effect on the health of regional banks.  

As the Bank of Japan is widely expected to be the last central bank to adopting a hawkish monetary stance, expectations for future action is limited. However, Kuroda may be implying that the Bank’s focus on a weaker yen may not drive future monetary policy. Instead, his focus is likely to shift to the shape of the yield curve which has hampered bank lending in recent years. As the Japanese yield curve has flattened, banking profits have fallen accordingly.

As inflation expectations fail to rise and the Bank of Japan hits the limits of monetary policy, the yen may surprise markets by strengthening in the near future.