At some stage, most likely within 1Q10 according to our Japanese economics team, the BoJ will undertake further QE-like steps to help address growing deflation fears (options include increasing JGB purchases, clarifying commitment to policy duration, cutting rates, inflation targeting and/or helping limit a rise in long rates), a move that will widen interest rate differentials and weaken the yen. While historically a rally in JGBs has almost always been associated with a fall in equities (and vice versa with a bond sell-off), we think the market may view more decisive action as a positive.

Historically, the performance of the MSCI Japan Index has inversely tracked the fortunes of the yen, which is especially true in recent years. In fact, the relationship between the MSCI Japan Index and the yen appears to be strengthening, with 5-year rolling correlations peaking in Nov-09 at 92%. Nonetheless, while fundamentally corporate Japan and key cyclical sectors (Autos, Tech Hardware and Capital Goods) are reasonably well positioned to leverage a global growth rebound, we look for a change in policy direction and the yen as the catalysts for an overall change in market view.

However, the move to buy Western equity markets as QE measures were implemented in early 2009 was to some extent a bet that policy action would be sufficient and successful. We think investors will be more cautious in treating Japan in the same manner, especially against a backdrop where other central banks are winding down QE measures. We prefer to play a weaker yen via an overweight on Japanese Industrials and exporters, rather than on the overall Japanese market.

Eoin Treacy's view The credit crisis initiated a widespread unwinding of the Yen carry trade resulting in significant Yen strength which offered a stiff headwind for the Japanese stock market. Announcements late last year that quantitative easing measures would be maintained not so much to support the economy but to reinvigorate the stock market and weaken the Yen were welcomed by investors.

Korean exporters derived a considerable relative advantage versus their Japanese competitors due to the strength of the Yen versus the Won from 2008 but this is now being eroded. The Won broke successfully upwards in the last week and a sustained move below ¥8.5 would be required to question potential for further upside. Just about every currency is now strengthening against the Yen which suggests that this is a broader-based move than purely Won strength.

The Nikkei-225 is currently testing the September highs where some resistance may be encountered but a downward dynamic and/or a sustained move below 10,000 would be required to question potential for a successful upward break. The continued failure of the Topix Banks Index to rally is a potential headwind for the wider stock market which would be more deleterious if it were to sustain a break below 125.