From Global FX Strategy Morgan Stanley, this via eFX
Our expectation for JPY to weaken broadly and especially versus USD is based on expectations around monetary policy, fiscal policy, the inflation environment and the banking sector. A higher USD/JPY is our highest-conviction trade across the G10 and EM space. We target 125 by 2107-end.
Monetary policy: The BoJ's yield curve control strategy has not only put a cap on the JGB yields below 10y maturity but has also applied a slope. If JGB yields start to rise as a result of rises in global bond yields then the BoJ will buy an unlimited amount of bonds by expanding its balance sheet. In contrast, yields in the US are higher and prone to rising, increasing the yield differential with Japan, supporting USD/JPY. Our economists expect the Fed to hike more than the market expects in 2017, supporting the USD side.
Fiscal policy: Both the US and Japan are expected to expand government spending in 2017, which should support risk appetite and thus could increase Japanese investment abroad. As USD/JPY rises, the incentive to FX-hedge foreign investment reduces, thus adding to upside for this pair. If the Japanese government does choose to increase debt issuance to fund fiscal spending, then the resulting rise in inflation expectations would accelerate the JPY weakness.
Japan's inflation rising faster than nominal yields which are capped by the BoJ should push real yields down. Real yield differentials suggest USD/JPY should currently be trading higher. We expect US nominal yields to rise and real yields to remain fairly muted. Japanese banks seeing a more predictable yield curve may be more incentivized to lend and take on more risk. Lending outside Japan should weaken JPY. Lending inside Japan should raise inflation expectations.
FX hedging: In 1Q16 it was Japanese investors starting to hedge more of their foreign assets that provided JPY strength. As USD/JPY moves higher, we believe that these hedge ratios may change, supporting our trade. The market is still broadly long JPY, which we think needs to shift.
Risks to our view: If global risk appetite turns rapidly weaker due to global growth worries, putting equities under large downward pressure, then Japanese investors may invest less abroad, strengthening JPY. The BoJ cutting interest rates unexpectedly and thus flattening the whole curve again would not.