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.
In public, G7 finance officials meeting in Sendai will likely repeat previous commitments not to manipulate exchange rates and to refrain from competitive devaluations.
The fear is that if Japan intervenes to weaken the yen, others - particularly China and other G20 emerging markets - may do likewise with their currencies. Privately, Japan may signal that the option of market intervention remains on the table.
Broad market volatility is still within historical ranges and policymakers would like to keep it that way -- but they will be reluctant to give any sort of blessing to Japanese intervention.
“Abenomics is doing so poorly right now that no matter what the G7 said, if dollar/yen goes below 105 and towards 100 Japan will intervene,” said Steven Englander, global head of FX strategy at Citi in New York.
“The Japanese may be willing to accept the international political consequences, as the domestic consequences of stronger yen and weaker equities are much more dire.”
Futures market data from the Chicago Mercantile Exchange shows currency speculators have turned hugely bullish on the yen in recent months and hold one of the biggest long positions - effectively a bet that an asset will rise in value - on record.
The yen hit an 18-month high of 105.55 per dollar on May 3, prompting Abe’s adviser Koichi Hamada to tell Reuters Japan would intervene if it firmed to between 90-95 per dollar, even if that upset the United States.
U.S. Treasury Secretary Jack Lew and others argue Japan has relied too heavily on monetary policy and should focus more on boosting domestic demand and structural reforms to make its economy more efficient.
To that end, fiscal stimulus from Tokyo might be more likely. But only if everyone is on board - by no means certain if fiscally conservative German Finance Minister Wolfgang Schaeuble has his way.
The yen has since slipped to almost 110 per dollar, perhaps a sign that FX traders are pricing in a degree of G7 support for Japan’s desire for a weaker exchange rate.
But that could be risky, says Steve Barrow, head of G10 strategy at Standard Bank.
“The only market reaction to G7 will probably be in the yen but it looks to me like the market may be a bit vulnerable if there’s a lack of support for Japan from G7,” he said. (Reporting by Jamie McGeever; editing by John Stonestreet)