Kambiz Kazemi, Partner & Chief Investment Officer
Inflation continues to be the talk of the town and latest CPI measures for major developed economies are all above 6%. But Japan remains a distinct outlier in the developed world. Japan’s latest year-over-year measure CPI was only 0.6% in February and at -1.0% (yes negative) excluding food and energy. And these are inflation numbers for a country that imports 94% of its energy needs.
The “why?” can be the subject of a lengthy note – not this one – which would end up highlighting that no one has a clear answer. But the differential in actual inflation, inflation expectations, which are only at 0.8% for a 10-year horizon in Japan, as well long-term nominal rates are part of that explanation. In this note we will have a look at the Japanese currency and how it has been faring of late, and share some thoughts on potential paths and risks ahead.
Since the start of war in Ukraine (end of February) the Yen has depreciated nearly 10% versus the USD while the US Dollar index is up 4%, making it the worst performing G10 currency by far.
Let us remember that over the last few decades the Yen was often described as a flight to quality currency which appreciated (vs. others) when there was talk of crisis of any kind. Yet, this time around its value is falling.
As Chart 1 shows we are at a multi-decade high for the USDJPY. One might be tempted to “sell the high” on this multi-decade top.
But in life, time is perspective. The same goes for the financial markets. The biggest trap for investors and risk managers alike is over relying on the recent past, and recent past can in some cases be decades long. Here is a look at the price of USDJPY since the breakdown of Bretton Woods in 1970.
What a difference three additional decades make! So, should one actually “buy this breakout” rather than sell the high?
To answer that question, let’s remember how we got here:
(Note: those who have traded and invested in FX markets over the last decade and a half have been told/thought that systematic and widespread sovereign currency intervention/manipulation in developed markets is taboo and unlikely to happen, a closer study of 1985 and 1987 might be very timely!)
Some takeaways and additional observations from this lookback are that:
Today, Japan has a trade deficit and the rise in commodity and raw material prices for an energy intensive and production-based economy are, at the very least, not constructive for the local currency.
If US – Japan rate differentials continues to widen (a very likely scenario in our view) coupled with persistent divergence in inflation expectations (which continues to be true so far), there is a non-negligeable probability that the Yen could further weaken to levels not seen since the 1980s, namely 150 or even higher.
At the time of writing; option markets price the probability of the USDJPY ending above 150 in 6 months and 1 year at 1% and 4% respectively.
In our view a realistic probability (barring Central Bank intervention in currency markets) is rather in the 10-15% range. Such divergence allows investors and hedgers to implement attractive strategies with limited risk via option structures.
More generally, those with exposure to the Yen should not dismiss the scenario of a noticeably weaker Yen.
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