Can The Yen Pull Itself Back Together?

Stéphane Renevier

2 months ago2:56 mins

Can The Yen Pull Itself Back Together?

The depreciation of the Japanese yen is becoming one of the biggest macro stories of 2022, with the currency falling by 11% versus the US dollar and reaching levels last seen more than 20 years ago. But with everyone betting heavily against the yen, is it time to be contrarian and buy the dip? Let’s take a look.

Why has the yen fallen out of favor?

First and foremost, investors simply are taking their money out of Japan. That’s because while interest rates are sharply rising almost everywhere in the world, they remain at rock-bottom levels in the land of the rising sun. There’s a good reason for that: the Bank of Japan (BoJ) has been implementing an even more extreme version of quantitative easing called “yield curve control” (YCC), consisting of not only keeping short-term rates low but also explicitly capping longer-term ones. Because investors can earn far more interest on their investments elsewhere, they’re fleeing Japan, increasing selling pressures on the currency.

Now even without the yield curve control in effect, it’s worth noting that Japan’s economy is in a very different place than the rest of the G7 countries: its economic growth is far lower and its inflation far milder, given Japan’s years-long battle with deflation. That led investors to put a very low probability on any change in BoJ policy, and created a one-way bet against its currency.

What’s more, rock-bottom interest rates have made the yen the go-to funding currency for “carry trades”. These are popular foreign exchange trades where investors sell the yen against higher-yielding currencies like the Australian dollar, allowing them to pocket the difference in yield between the two. And since they’re selling the yen, it’s been sending the currency’s value lower and lower. Speculators and trend-followers have further exacerbated the fall: by jumping on the bandwagon to profit from a falling yen, they’ve pushed the currency faster toward the bottom.

Has the yen fallen too far, too fast?

It’s a possibility. The drop in the yen has been steep, and it’s fallen against multiple currencies, not just the US dollar. And its current real effective exchange rate (REER) – the value of the currency against a weighted average of its major trading partners – is almost three standard deviations below its recent average. That suggests prices might have overshot their fundamentals, and increases the odds of a rebound.

The yen might have fallen too far, too fast. Source: TS Lombard, Bloomberg
The yen might have fallen too far, too fast. Source: TS Lombard, Bloomberg

The yen is also considered the most undervalued G10 currency versus the dollar, according to its “purchasing power parity” – a measure of how much a country’s currency can buy.

The yen is the cheapest G10 currency based on valuation. Source: Bloomberg
The yen is the cheapest G10 currency based on valuation. Source: Bloomberg

Now, valuation alone isn’t reason enough to make an investment. But with the yen so low, I can’t see too many scenarios – other than US interest rates blasting through the roof – that could cause the yen to weaken even more. In fact, I’d say that the balance of risks is turning.

Why might the yen rise?

First, markets may be underestimating the risks of a change in policy. Sure, a weak yen can be positive for the economy, but not if it gets too weak. If inflationary pressures squeeze consumer spending or corporate profits by too much, there’ll be more pressure for the BoJ to reverse course on its ultra-accommodative monetary policy. And that could take two forms: the BoJ might relax its yield curve control program (by raising how high the yield can go, for example, or by changing the maturity of the bonds it targets), or the Ministry of Finance could intervene in forex markets directly, as a higher yen would be another way to fight off inflationary pressures. The market wouldn’t even need to see decisive action for the currency to react: a gathering pace of that narrative should be sufficient to put a floor under the yen.

Second, US bond yields and commodity prices aren’t likely to keep rising at the same rate. In fact, the risks to economic growth are dampening their outlook. That will mean less pressure on the Federal Reserve to hike interest rates aggressively, which will make US assets less appealing. Even a pause in the yields and commodity price rally would likely be enough to trigger a relief rally for the Japanese currency.

Third, the yen’s technicals could quickly turn from headwind to tailwind. Investors might start to take profits at current levels, and longer-term value investors could start to emerge. That’ll re-establish some balance between supply and demand and help stabilize the currency. Plus, a more uncertain macro environment will probably increase volatility, which makes life more difficult for higher-yielding currencies and could force investors to close their carry trades. And finally, the yen is currently trading near key support levels against the US dollar, which should support the currency.

What’s the opportunity here?

You could, of course, buy the Japanese yen, which seems like an attractive opportunity in the medium term. And the next few weeks might offer some attractive entry points, with a BoJ meeting and some important economic data releases on the horizon.

But what currency should you sell to buy the yen? The cleanest option would likely be to sell a basket of Asian currencies, though that can be complicated to implement. Shorting the US dollar makes sense too: the dollar is one of the most overvalued currencies out there and the easiest and cheapest to trade. If you have a bearish view of the global economy, or want to use the trade as a portfolio hedge against a recession, you could also consider selling higher-yielding currencies like the Australian dollar or Canadian dollar – a trade that should pay well in a risk-off environment.

You can do the trade either via the spot market, or via derivatives like contracts for difference. If you only want to trade stocks, your options are more limited, but there is one ETF that lets you bet on a higher yen versus the dollar: Invesco Currencyshares Japanese Yen Trust (ticker: FXY, expense ratio: 0.4%). That fee is pretty high, mind you, so it may not be a great option for the long term.

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