G7, markets face struggle to quell yen volatility

Wed May 18, 2016 8:31am EDT
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By Jamie McGeever

LONDON May 18 (Reuters) - For world markets, the main focus at this week's Group of Seven meeting in Japan will be how much leeway the host nation is given to boost economic growth and inflation, specifically through depreciation of the yen.

Japan's economy is struggling in the face of a stronger exchange rate that has damaged growth, intensified deflation, crushed stock prices and prompted the Bank of Japan to impose negative interest rates on certain bank deposits.

Though the economy expanded at its fastest pace in a year in the first quarter, analysts said Wednesday's data was not strong enough to dispel concerns over a contraction this quarter.

In short, 'Abenomics' remains in trouble. The question is what Prime Minister Shinzo Abe can do to restore Japan's economic fortunes without incurring the wrath of his G7 partners. For that, read direct intervention to rein in a currency that has rallied 10 percent so far this year.

The yen's swings are a broader reflection of market sentiment around the world. A rising yen hurts Japan's economy, but also signals investor caution, a decrease in risk appetite, and money going to ground globally.

In a world where growth and investment returns are low, policymakers would prefer not to have high volatility around a strengthening yen.

That was the scenario earlier this year when its rally coincided with a steep fall in world stocks, wider credit spreads and a spike in volatility, a confluence of events in part fuelled by the BOJ's imposition of negative rates.

Dollar/yen implied option volatility spiked to its highest in almost three years as world markets suffered.   Continued...