- The yen remains out of line with its fundamental drivers, thanks in part to a surge in yen crosses which are at risk of reversing should the risk recovery unwind.
- In the event of continued dollar weakness, we would expect the yen to join in with the other majors, or at least not depreciate.
- After being long EUR, GBP, AUD, and JPY since early-May, we are now shifting the majority of our currency exposure to the yen.
After a period of weakness, the yen has bounced back strongly in recent days, driven in part by a stalling in risk appetite and a reversal in yen crosses. The yen remains out of line with its fundamentals in the form of real bond yield spreads. We think the yen should be trading significantly stronger against the other FX majors, particularly given the rising social unrest in the U.S.
We have moved our exposure away from the Aussie and euro into yen. In the event of continued dollar weakness, we would expect the yen to join in with the other majors, or at least not depreciate. If the dollar strengthens, on the other hand, it is likely to be a result of rising risk aversion, which should be positive for the yen versus the other FX majors.
Yen Trading Out Of Line With Fundamental Drivers
We first turned bullish on the yen back in late-February (see ‘Yen Bull Market Remains Intact‘) due in part to the threat posed by a crash in U.S. stocks. While we saw some yen strength in the initial part of the equity decline, the dollar liquidity crisis dwarfed yen repatriation demand. Since then, a strong risk recovery has undermined the yen again. Even after the past two days of gains, the yen remains out of line with its fundamentals.
EURJPY Vs Spread of Germany over Japan 10-Year Bond Yield
Rising risk appetite tends to undermine the yen as low bond yields mean traders often borrow in the currency to purchase higher-yielding assets. Typically, EURJPY has risen in response to expectations of higher interest rates in the eurozone as shown by the close correlation between the cross rate and the spread of 10-year bond yields between Germany and Japan.
Germany Vs Japan 10-Year Inflation-Linked Bond Yields
We see two reasons to expect the EURJPY cross to struggle to push higher from here. Firstly, the cross has moved far above where the spread of 10-year yields would suggest is warranted based on historical correlations. Secondly, the rise in the nominal yield spread that we have seen belies the real interest rates spread, which has remained depressed. Ultimately, higher nominal yield differentials between Germany and Japan will only lead to sustainable gains in EURJPY if they reflect tightening monetary policy and/or improved relative growth prospects as opposed to higher inflation expectations as is currently the case.
Source: Bloomberg, author’s calculations
As a result of the rise in yen crosses, USDJPY remains above its short-term fair value implied by U.S. – Japan real yield spreads. While U.S. 10-year nominal yields have risen much faster than Japanese yields, the increase has been offset by the relative rise in inflation expectations in the U.S., which has left real yield spreads near all-time lows.
U.S. Vs Japan 10-Year Breakeven And Yield Spreads
Japan’s Economic And Social Stability Warrant A Yen Premium
Our view is that a renewed rise in risk aversion would benefit the yen due to a reversal in yen crosses, while in the event of a continued dollar selloff, we would expect the yen to join in the rally. In fact, should we see another escalation in riots in the U.S. and Western Europe, Japan could become a safe haven destination once again. Japan’s stability in terms of its huge external asset hoard and its relatively high level of social cohesion suggest the yen should be trading at a premium, not a large discount, to its historical fundamental drivers.
From a longer-term perspective, the U.S. looks set to continue running large fiscal deficits in part aimed at maintaining social stability, which should keep inflation elevated relative Japan and real yields more deeply negative. Japan’s current 60bps advantage in terms of 10-year real yields reflects the likelihood that monetary policy remains more prudent than in the U.S., supporting the yen in both nominal and total return terms. When we add the fact that the yen is deeply undervalued in real effective exchange rate terms, we think the yen is an attractive risk-reward prospect right now. After being long EUR, GBP, AUD, and JPY since early-May (see ‘The Dollar Debate: Taking The Under‘), we are now shifting the majority of our currency exposure to the yen.