Against the tide
The Japanese yen has responded to risk aversion in this way for decades. Despite holding its own against most other currencies during the most difficult days of the Greece negotiations, the euro still lost around 2% against the yen.
We are cautiously overweight the yen but market positioning suggests we are fighting the consensus on this.
Japan’s Government Pension Investment Fund (GPIF) and other local investors have been allocating away from domestic government bonds and into global risky assets for some time now, and trend followers have jumped on this move.
Who can blame them? We are two-and-a-half years into Abenomics and its ‘three arrows’ of monetary easing, fiscal stimulus and structural reform.
The main objective of this programme is to get Japan’s inflation back to 2%, and one consequence of the resulting interventions by the BoJ has been to send everyone abroad in search of yield.
When inflation finally returns, the BoJ will be able to slow its aggressive programme (as the Fed did last year) and, at that point, the yen may turn (as the dollar did last year). Until then, it must surely continue to print money to keep the yen highly competitive against its trading partners.
However, the yen trade-weighted exchange rate has plummeted 33% since January 2012.
From a real exchange rate perspective, our assessment suggests it is now the cheapest G10 currency, undervalued, on average, by 25% against that basket.
History suggests these currencies cannot sustain large misalignments of more than 25% to 30% for long. Inflation may not be the catalyst for the BoJ to remove ultra-loose policy just yet but a weak currency boosts exports, leading to a rising current account balance that eventually leads to demand for yen.
We saw a sharp turn in Japan’s current account during 2014. Moreover, complaints from US carmakers that they feel they are competing with the BoJ rather than Japanese carmakers are intensifying.
Most of the yen’s depreciation occurred during 2012. Since then it has traded in a range despite the BoJ expanding its programme in April 2013 and October last year.
That suggests any further expansion of the programme would have to be substantial to effect another downwards lurch in the currency. As such, while the BoJ can keep the yen low for a long time, the upside on a short yen position looks limited versus the downside should all those domestic investors repatriate capital in the event of a bout of risk aversion.
The last time the yen was this cheap was in 2007: it was nearly 50% more expensive by the time the financial crisis had done its worst.
Speaking franc-ly
So much for currencies we believe to be oversold. Which is the world’s most expensive?
