Japan GDP Report Means Weaker Yen

NEW YORK ( TheStreet) -- Last Friday, the Japanese yen completed its best weekly performance since June, hitting levels of more than 96 against the dollar.

These moves were relatively surprising, given the lack of currency volatility that is usually seen during the summer months. But this strength in the yen should be viewed as a selling opportunity, as second-quarter GDP growth in Japan is suggestive of a major reversal that will likely generate a period of prolonged weakness in the currency.

This week's data show the Japanese economy grew at a slower rate of 2.6% (on a yearly basis), as reductions in business investment undermined increases in government spending designed to end decades of well-publicized deflation.

These results are significantly less than the 3.8% rate posted in the first quarter and the market's consensus estimates of 3.6%. Additionally, July's industrial production figures fell by 3.1% when compared to the prior month.

In all, these numbers will lead to more vocal arguments that the Bank of Japan's aggressive quantitative easing programs (the so-called policies of Abenomics) have been largely ineffective, and that additional stimulus injections will be needed as a means to support the country's struggling economy.

This is a clear negative for the Japanese yen, as any further central bank easing will be directed at weakening the currency in support of export companies. Investors with active exposure in the CurrencyShares Japanese Yen Trust ETF ( FXY) should be looking to sell in favor of instruments that track the greenback, such as the PowerShares DB US Dollar Index Bullish ETF ( UUP).

Sales Tax Delays

With the positive moves in the yen last week, current levels offer excellent risk-to-reward ratios for trades positioned to benefit from the yen weakening against the dollar. But recent inaction from the Bank of Japan could lead to speculation that additional stimulus injections might not be seen. Part of the reasoning behind last week's strength in the yen has been the central bank's apparent reluctance to introduce new stimulus measures.

Because of these possibilities, the fiscal space will be the first area to watch.

Official statements suggesting delays in proposed sales tax hikes could be the first indication that the Bank of Japan is ready to move forward with renewed changes in its policy stance. Early proposals suggest a 3% tax increase will be implemented in April. But now the main question will be whether this imposition will limit the ability of the Japanese consumer to continue spending at supportive rates.

The latest GDP figures and the reductions in capital spending by Japanese companies in the last six quarters suggest this is an unlikely outcome -- and that the Bank of Japan will have no choice but to continue easing its policy stance. The general lack of corporate adherence to Abenomics means that the Japanese Prime Minister will be forced to renew his commitment to stimulus in coming months. Outcomes here are likely to show a direct contrast with what will be seen from the Federal Reserve, as current stimulus packages in the U.S. start to see cutbacks.

All of this points to additional upside in the USD/JPY and continued weakness in the Japanese currency. As broad-based economic figures ultimately suggest the country's historic stimulus programs are not aggressive enough, central bank commentaries will be the main driver of volatility in the currency going forward. The yen has fallen nearly 20% in the last year, but the rallies seen earlier this month create new opportunities to sell, and to move into assets denominated in dollars.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Cox is based in China, and has lectured at several universities there on international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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