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Japan Macro Watch
USD/JPY: Buy-on-dip cycle to continue; 115-120 by end-2017
Bank of America Merrill Lynch
14 November 2016

Buy-on-dip cycle continues
While we had acknowledged the risk of the "final JPY strength" this autumn on the BoJ's limit and US elections, it has been our view that the USD/JPY's dips was to be bought as the 100-105 level was where medium-term directional risk was likely to reverse to the upside (Dollar's 100 Yen risk 02 March 2016). In our view, a Republican sweep would first lead to JPY strength on risk aversion, but eventually be the most bullish outcome for the USD/JPY. The price action last week – a shallow dip – tells us two things about the USD/JPY. First, the view that a GOP sweep would boost the USD/JPY was probably more widely shared than we had thought, so a dip failed to stretch. Second, there may be more potential USD/JPY buyers than sellers, which is in stark contrast to last year, when there were many more potential USD/JPY sellers than buyers (Case for a stronger yen in 2016 18 December 2015). The "buy-on-dip" cycle in USD/JPY is likely to continue as we expect the pair to reach 115-120 by end-2017. We remain constructive about Japanese equities and see banks, insurance continue performing REITs near-term.

Higher US rates (esp. if steepening) to boost USD/JPY
USD/JPY performs best at the time of UST bear-steepening as better risk sentiment reduces the JPY's safe haven demand and a wider yield spread increases the USD demand from Japanese investors (Exhibit 2). For our US strategists, the clean sweep means fiscal easing and higher rates, supporting their higher real rate view (A win for bond bears and USD bulls 09 November 2016). The USD/JPY has recently tracked real yield spread closely (Chart 1), and the pair is gradually producing higher carry as monetary policy is diverging between the US and Japan (Chart 2). In Japan, fiscal easing is also a possibility in light of reduced odds of TPP implementation and a potential early snap election. Any positive impact of Japanese fiscal easing on growth is likely to manifest itself in higher inflation expectations under the BoJ's yield-targeting regime, which means Japanese real interest rates can actually fall.

Watch Abe-Trump meeting – coordination or conflict?
Given the high uncertainty, clarifications on Trump's policies on trade and currency will be important for the Japanese market going forward. A potential Abe-Trump meeting in New York this Thursday (17 Nov), as reported by Japanese media, warrants attention. We suggested that Trump presidency could potentially reduce flexibility of Abe's political and diplomatic strategy, reduce positive market risk from Japanese politics, and increase negative risk from Japan's national security. But this is not known until we see actual Trump presidency. If the President-elect shows an understanding for the existing Japan-US alliance and refrains from protectionist rhetoric, it could reduce concerns about deterioration of the bilateral relationship, supporting USD/JPY and potentially exporter shares (though reduced odds of TPP implementation is unlikely to change drastically).

Investment Strategy
Japan

Shusuke Yamada, CFA >>
FX/Equity Strategist
Merrill Lynch (Japan)
+81 3 6225 8515
shusuke.yamada@baml.com

Paul Ciana, CMT
Technical Strategist
MLPF&S
+1 646 855 6007
paul.ciana@baml.com

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Timestamp: 13 November 2016 06:10PM EST
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