Downward revision for the yen’s profile. After a long phase of immobility, the long-awaited downside reversal of the yen has suddenly begun. .……
For professional investors and advisers only
The decisive factor in triggering the movement was the BoJ’s decision to adopt an inflation-targeting regime. But will this be enough to hold the new course?
We revise down the yen projections (see Tab.): regaining the USD/JPY 90 level seems to be easier now.
After over six months in the waiting, during which the yen “moved” between USD/JPY 76 and 78, the long-awaited downside reversal of the yen has suddenly begun. The decisive factor in triggering the movement was the BoJ’s decision in February to adopt an inflation-targeting regime.
But will this be enough to hold the new course? We deem that both the choice of the new strategy, and its timing, should help keep the downside trend in place. The yen displayed strong downside resistance throughout 2011, and in the opening weeks of 2012. In this period, one of the main factors that in some instances strengthened the yen, and in some other limited or prevented its decline, was the phase of persisting risk aversion2, which traditionally enhances the Japanese currency’s role as a safe haven, as was the case in the past for the Swiss franc, and in some cases still is for the US dollar.
However, there are two additional aspects which may at least in part justify the behaviour of the yen: (1) the dynamics and level of Japanese interest rate/government yields in relation to the United States’, and (2) the dynamics of inflation, i.e. lingering deflation.
(1) The levels and the interest rate/yield differentials between Japan and the United States, provided a good explanation of the trend of the USD/JPY exchange rate before the global economic and financial crisis of 2008, but continued to do so also subsequently (Fig. 1).
We will consider here 2yr government bond yields, as they reflect growth and inflation prospects, as well as the correlated monetary policy expectations. Considering the period between the beginning of 2005 and now, based on (average) weekly data, a correlation of 92% emerges between the USD/JPY exchange rate and the short-term yield differentials between the United States and Japan. The estimates resulting from a linear regression of the exchange rate on differentials have good explicative capacity (fitting, Fig. 2). Proximity to zero of both US and Japanese yields, as well as the former’s upward stickiness (the Fed has committed to keeping official interest rates close to zero at least until around mid-2014), and the near-impossible prospect of the latter dropping (they cannot drop any lower than zero: the average level recorded in the first three weeks of March was 0.11%), not only significantly limited the yen’s potential downside, but also kept its fluctuations within a narrow range for an extended period of time.
(2) On the other hand, the yen was at length pushed upwards, towards an appreciation, by Japanese consumer price dynamics in relation to US prices (Fig. 3) and, in particular, by lingering deflation in Japan. An approximate estimate of the correlation of purchasing power parity seems in any case to suggest that, although the yen followed the direction imposed by inflation differentials, lately (since shortly after the beginning of 2010, Fig. 4) it exceeded a little compared to these as well, i.e. it appreciated a little too much.
Such excessive upward bias is partially explained, as discussed above, by the rise in risk aversion on the international markets. Given these conditions, how could the yen reverse its course and start out on the long-awaited depreciation trend? Not even the BoJ, with its direct interventionson the currency markets (purchase of dollars against the sale of yen) was capable of triggering the movement. However, it did manage to contain the appreciation.
In February, however, the coup de theatre came: the BoJ announced the adoption of an inflation targeting regime, adding that, given the need to stably restore inflation to levels above zero, it would adopt further expansive monetary policy measures. This official change in strategy, announced at the right time, i.e. (A) when foreign trade data began to outline the risk of a structural inversion of trade balances (from historically positive to negative), also because of the exchange rate’s appreciation, and (B) when risk aversion had started to ease, in step with a “definitive” solution to the Greek crisis being approached”, broke the yen’s impasse at last, and triggered the long-awaited downside reversal.
As a result, now conditions seem to be in place in terms of (i) fundamentals, (ii) the market, (iii) and the institutional context, for the depreciation of the Japanese currency to continue.
However, the downtrend, while clear in underlying terms, may at times prove slower and more gradual, and/or undergo interruptions due to lateral movements. It should not be overlooked that rates are close to zero both in Japan and in the United States, and that for the time being there are still no indications of them possibly breaking the deadlock for at least the next 12 months.
In any case, it is legitimate on a one-year horizon to assume a widening of the short-term yield differential. Simulating a rise from 25bps at present to 100bos in a year (Fig. 1), using the model based on yield differentials described above, the result is that the yen may rise back to (just) above the USD/JPY 90 mark (Fig. 2). It cannot be ruled that this may take place even before then. What’s more, the fitted value yielded by the yield differentials-based model suggests that even now, at current levels, the yen is overvalued (Fig. 2: fitted value of 86.38 vs. actual value of 83.06 for the USD/JPY exchange rate), and even the purchasing power parity model already places the exchange rate at least at USD/JPY 90 (Fig. 4: estimated purchasing power parity value at 92.50 vs. actual value of 76.96 for the USD/JPY exchange rate, in the last reference month of the sample period considered).
Lastly, the prospect of the inflation differential curve (Fig. 3) reversing its trend, albeit gradually and moderately, also thanks to the official adoption of an inflation targeting regime by the BoJ, should make a not negligible contribution to safeguarding the new trend of the yen.
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