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Putting USD and JPY under the spotlight

In times of volatility the Japanese yen (JPY) often strengthens and, in mid-December, we saw the start of a material re-pricing of USD/JPY.

Repatriation flows of Japanese investors that tend to invest overseas, or collective carry position unwinds that have been funded out of ‘cheap’ Japanese interest rates, tend to lift the exchange rate in times of volatility.

So far JPY has appreciated by about 5% since the start of December (figure 1).

USD graph

Interestingly, when we look across a range of assets, we notice that risk premia have become less stretched in the first weeks of this year, for example higher stock markets and a narrowing in credit spread for high yield bonds.

However, USD/JPY is still subdued. Is there an opportunity here? 

Discipline

There are several drivers that we’ve found to have predictive power in driving currency returns, that we focus on in our investment process and then ‘score’ in a consistent way.

We recently noticed that one of these drivers – a behavioral-based one that’s influenced by investor sentiment and positioning – is turning positive on USD/JPY (long USD, short JPY).

We’ve observed that investor sentiment tends to work well at the extremes as a contrarian indicator – evidence that investors tend to overreact and herd.

Sentiment for USD/JPY is exceptionally negative at the moment, leading to the behavioural driver turning positive on USD/JPY (figure 2).

Sentiment towards USD

Additionally, interest rate differentials, also known as ‘carry’, are also supportive for a positive trade on USD/JPY, since USD cash interest rates have been on the rise.

The language of the Federal Reserve (Fed) has shifted, and turned more neutral recently.

The Bank of Japan (BoJ) is in the process of stepping away from their yield-curve-control policy by gradually widening the band where interest rates can drift freely.

Thus borrowing at negative interest rates in JPY and investing in USD comes with a positive interest rate differential.

Value

Given the long streak of JPY weakness and given where ‘fair-values’ will gravitate towards given the persistent difference levels in the rate of inflation, JPY is ‘cheap’ is by approximately 25% based on purchasing power parity (PPP) measures.

Here, we’ve observed that valuations have little predictive power in the short run, but do tend to add value when taking a longer horizon.

All in all, this leaves us with the observation that USD/JPY has not yet reversed part of December’s rout, while some capital market have done so.

Our indicators show that investor sentiment is excessively negative on USD/JPY at the moment, and therefore in favour of buying USD/JPY.

Given positive interest rate differentials, time is on your side. Since valuations are rich (i.e. expensive USD and cheap JPY), any long USD/JPY trade based on the rationale above should have a shorter time horizon.