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Why a Fed hike is good news for Japan stocks

Japan's market suffered through the recent market rout along with the rest of Asia's stocks, but its shares may actually get a fillip from a Federal Reserve rate hike.

"The single most important driver of equity performance in the next year or so is likely to be renewed weakness in the yen," Julian Jessop, chief global economist at Capital Economics, said in a note Tuesday. He expects the Nikkei will hit 23,000 by the end of 2016; the index was trading around 18,135 Wednesday.

Jessop sees two drivers of further yen weakness: expectations the Bank of Japan (BOJ) will expand its quantitative easing program, possibly as soon as next month, and a Fed hike.

The lady or the tiger drama around whether the Fed will increase interest rates for the first time in more than nine years at its meeting this week helped drive a global market selloff amid concerns over tightening liquidity.

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But Jessop estimates that if the spread between the two-year U.S. and Japanese government bond yields widens to one percentage point - it's currently around 70 basis points - that would justify the yen falling to his end-2016 forecast of 140 against the U.S. dollar, from around 120.20 Wednesday, and thus driving the Nikkei higher.

A rise in U.S. bond yields relative to Japan's makes Japanese assets less attractive, helping to spur outflows that weaken the yen; a weaker Japanese currency typically boosts the country's stocks as it makes exports more attractive and overseas earnings look plumper when they are translated back into yen.

To be sure, the Japan market has already had quite a rally, surging nearly 75 percent since the beginning of 2013 and up nearly 4 percent so far this year despite doubts over whether Abenomics, as Prime Minister Shinzo Abe's plan to kickstart Japan's economy out of its decades-long deflationary slump is known, will see any success.

Much of the rally had been driven by the first "arrow" of Abenomics - a massive quantitative easing program from the Bank of Japan, which sent the yen sharply lower and boosted interest in stocks.

The "second arrow" was meant to be fiscal stimulus. Some analysts have grown weary of waiting for promised structural reforms, dubbed the "third arrow."

Although markets have gained on Abenomics, the world's third-largest economy hasn't responded all that much to the arrows, shrinking an annualized 1.2 percent in the April-to-June quarter, while inflation has fallen well short of the BOJ's 2 percent target, coming in at essentially zero in July data.

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Underscoring some of the concerns over the durability of the recovery, U.S. ratings agency Standard & Poor's Wednesday downgraded Japan's credit rating to A+ from AA-.

Not everyone expects the BOJ will introduce fresh easing. DBS expects Japan's central bank to watch the impact of any Fed hike on the foreign-exchange market before moving.

"Overall, there appears to be a reluctance to further expand the monetary base target," DBS said in a note Wednesday. "If the yen is to weaken again, it will have to come from a stronger U.S. dollar." That means watching the Fed's moves.

But Capital Economics is far from alone in anticipating the BOJ will increase its 80 trilllion yen ($670 billion) worth of asset purchases annually, thus pushing down the value of the currency.

"I think there will be more money printing from the Bank of Japan," possibly by year end, David Roche, global strategist at research house Independent Strategy, told CNBC. "They have an inflation target ahead and they're going to have to print more money to hit the inflation target."

A pedestrian holding an umbrella walks past an electronic board showing prices of Japan's Nikkei average in Tokyo.
Yuya Shino | Reuters
A pedestrian holding an umbrella walks past an electronic board showing prices of Japan's Nikkei average in Tokyo.

He expects that some of that stimulus may flow directly toward the stock market, as central bank appears to be running out of people willing to sell it Japanese government bonds, spurring the BOJ toward buying other risky assets, such as stocks.

"The nice thing about the Bank of Japan is they can go buy anything -- they can buy rusty bicycles if they feel like it. But of course they move into equities and other things like that," he said.

The quality of Japan Inc. investments may also be improving.

Roche believes the "third arrow" largely failed to take flight, but he noted that Abe has succeeded in boosting corporate governance. "We're getting companies actually being run to make money now," Roche said.