The Yen Will Get There, Eventually

The Japanese yen’s cheapness has made it a compelling currency. However, the yen’s popularity as a funding currency for carry trades, the difficulties of predicting interdependencies and divergences in cross-country rates and yield curves, and a slow-moving Bank of Japan (BOJ) also have made it a challenging currency to size and hold. Still, we believe there is a case for being long the yen.

The Case for Mean Reversion

The yen effectively strengthened for around twenty years on trend only to weaken for roughly the next twenty years, overshooting on the downside (see Exhibit 1). This trend suggests the potential for some mean reversion.

What is more interesting is that in recent months, the relative carry, which has been negative, has been moving in favor of the yen, particularly against G10 currencies. The reason for this shift is markets are pricing in easing cycles in most G10 countries and a tightening cycle for the BOJ. Even more recently, there has been an odd divergence between the carry, which is now moving in favor of the yen, and the actual currency performance (see Exhibit 2). We believe this dislocation supports maintaining a position in the currency.

Japan’s strong current account balance also makes a case for the yen (see Exhibit 3). The large current account surplus, the cheap currency, and a carry that is now becoming less negative all provide a favorable backdrop. We would contend that it is the change in carry—not the level—that should matter.

History of Japan’s Currency Interventions

Looking at the historical USD/JPY exchange rate, Japan’s Ministry of Finance has a reasonably sound track record with regard to currency interventions. While not all measures have been extreme, most have had reasonable success, generally coinciding with turning points in the yen’s trend (see Exhibit 4). In our view, it is generally a helpful factor to have the Ministry of Finance effectively on the side of the yen.

There has been a divergence in the relative rate spreads of G10 currencies, and this relative rate spread has started to move in favor of Japan. Until recently, the currency was at historical weak levels, resulting in a massive build-up of different forms of yen-funded carry trades. As we have seen over the last several weeks, the unwinding of these carry trades can cause violent market reactions at times. We believe positions in the yen come with some asymmetry, with the potential to lose value slowly but recoup those losses and then some in a short space of time when conditions turn.

What Is the Yen’s Fair Value?

Some models put the fair value of the yen at around ¥80 to ¥90 for 1 USD. With the USD/JPY exchange rate currently around ¥146 after having weakened to over ¥160 in July, there is plenty of room for the yen to appreciate. In a moderately risk-off world in which the Federal Reserve is actively cutting rates and U.S. unemployment is moving higher, we would see ¥120 as a reasonable target.

Roadmap for Further Yen Strength

The BOJ’s first rate hike in 18 years was a watershed event. However, it also caused a violent re-pricing in the Japanese stock market and the yen. The BOJ has since guided the market toward calm by indicating it would not raise rates while the market remains volatile. Despite the recent equity market volatility, domestic companies’ sentiment has not altered drastically. Therefore, the strength in the capital expenditures (capex) cycle is likely to continue. Concurrently, we continue to see more evidence of stronger wages working their way into higher real consumption in Japan. We believe this feedback effect, which had been absent for two decades in Japan, will allow the BOJ to continue hiking rates into next year. This trend will create a tailwind for the yen while supporting an underweight position in Japanese government bonds (JGBs).