9 January 2014 FX Blueprint: Thin end of the wedge External accounts highlight major vulnerability Japan's balance of payments still promises a brisk tailwind for yen weakness. The trade account has deteriorated further, against most expectations of stabilization. This is overwhelmingly an oil and gas story, though lackluster external shipments and strengthening domestic demand are supplementary issues. Net FDI outflows a similar-sized drag that is only likely to get bigger even if the current account gradually improves. That reflects a massive cost-of- funding advantage spurring catch-up after Japanese corporates have been risk averse and lagged their competitors in overseas expansion over the last two decades. Overall it leaves Japan's 'narrow basic balance' in a pretty neutral state (middle chart). Cross-border portfolio flows have also had little impact on the yen thus far. Foreign equity inflows seem to have been largely hedged and new bond outflows were limited to banks' offshore treasury activity. Henceforth, real money inflows to Japanese stocks should pick up, but will probably be balanced by growing Japanese outflows into foreign bonds and stocks - the latter encouraged by the new NISA scheme and more aggressive GPIF portfolio adjustment away from JGBS. That would leave the financial account's short-term loans balance as largest swing factor again. It captures carry trades and foreign asset hedging activity and responds to risk aversion and investor's perception of long-term interest rate differentials. It is several orders of magnitude larger than other BoP components and seen in stock terms retains scope for several hundred billion dollars of yen-selling unwinds (lower chart). Abenomics abound Conventional market tops are characterized by hubris in the mainstream which creates unquestioning acceptance of a 'new status quo.' By contrast, most forecasts for Japanese asset prices strike us as intensely conservative as