Japan

Our sense is that the current reflation trade will extend into the summer, sending stock and commodity prices higher and the U.S. dollar down. Global government bond yields should rise during this phase. Beyond the near term, we expect these reflation trades to go into reverse. Stay defensive.

The dollar countertrend move has more downside, but beyond the next few months, the dollar remains in a cyclical bull market. Improvements in global growth, even if temporary, are likely to lift non-U.S. rates more than U.S. ones. The euro will benefit from that move as investors still have deep negative feelings toward EUR/USD, exactly as economic momentum has moved in favor of Europe. The SEK should outperform.

The United States and China continue to see relations worsen, particularly over China's activities in the South China Sea. But that is not the only reason geopolitical risk is migrating from the Middle East into Asia Pacific - a trend that investors cannot afford to ignore.

Japanese policymakers are in the process of shifting away from negative rates and fiscal consolidation, leaving JGB yields exposed to any move to weaken the yen that could raise depressed inflation expectations.

This week <i>Global Alpha Sector Strategy</i> in conjunction with <i>Emerging Markets Strategy</i> is sending out a <i>Special Report</i> on EM deep cyclical sectors, discussing debt and cash flow dynamics, identifying how far advanced the capital expenditure down cycle is, and determining if recent EM deep cyclical strength should be bought or faded.

Japan is in a liquidity trap: bad economic news is good for the yen while good economic news is bad for the yen. Chinese reflation could help risk assets in the months ahead, but poor EM fundamentals will reassert themselves later this year. The yen bull market is not over yet. The BoC was more positive on growth than anticipated. The BoE's Super Thursday was a non-event.

A stronger yen is hampering efforts to revive the Japanese economy and the BoJ's failed NIRP experiment leaves open the option of direct currency intervention. Probability is also high that the April 2017 sales tax hike will be postponed, perhaps indefinitely. A major stimulus package, "helicopter drops" of money, and a 4% inflation target may be the only way to permanently overcome deflation. Near-term, further yen strength is likely, but the long-term path is down.

Clients should forgive us for being too gloomy at the start of the year -- it is difficult to be optimistic in the dead of a Montreal winter. However, with springtime comes the reflation trade, born on the wings of massive Chinese fiscal and credit expansion. In this report, we discuss how long (not very) the trade can go (and how to play it). Our In Focus feature returns to pessimism, with a discussion of why the Anglo-Saxon laissez-faire economic model may be in for a big pendulum swing.

In this piece, we present our general analytical framework, with a focus on long-term determinants. We go through various methodologies and relate those methods to our views and current FX market developments, concluding that the dollar bull market is not over, EM currencies have more structural downside, and that it will take herculean efforts from the BoJ to arrest the yen surge.