Yen Behaving Badly

With apologies to readers less well-versed in the 1990s British sitcom subculture. And ‘badly’ of course depends on your perspective. Perhaps ‘strangely’ would be better. Then again, looking at Figure 1, you’d be forgiven for thinking that this was a headline in search of a story. Then again (again) we are still at trailing 10-year highs on a realised risk basis, while implied volatility is spiking, even if not to the extent of prior stress points. Moreover, the chart fails to capture the exogenous debate: all those knowing allusions to the Japanese yen carry trade we’re all pretending make perfect sense. Here’s my two sen’s worth on the current state of play. Worth a bit more, I hope.

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The yen is very (very) cheap. At least as the purists would look at it. Figure 2 shows the relative discount/premium of JPY versus three purchasing power parity (PPP) models, which imply that, relative to the dollar, the currency is valued as cheaply as at any point since at least the early 1970s. The pragmatists would counter that PPP is a nice idea which doesn’t survive first contact with reality. Due to tariffs and other trade restrictions, unconventional monetary policy, basket compositional issues and so on. All fair.

But over longer time horizons, a child’s playground trading logic says purchasing power must have some bearing on the relative attractiveness of a given token. And it is also partially borne out in the empirics. Taking the six local troughs in the three lines of Figure 2 (Feb ’85, Apr ’90, Jul ’98, Mar ’02, Jun ’07 and Jul ’15), the five-year forward yen move against the US dollar averages 6% annualised, appreciating in 100% of instances. Today, the carry trade, as well as other technical gyrations, are being amped up by valuation elastic which is as taut as it has been in living memory. Let’s not be surprised if that results in some large moves.

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Source: OECD, The Economist, Bloomberg, Man Group calculations. For our model we are indebted to the work of Chester Ntonifor at BCA Research. We split the CPI baskets of US and Japan into 10 broad categories, take the weighting of each, and then take the average of those weights to create a custom US-Japan equivalent goods baskets. We then apply the percent change in the ratio of these baskets to the USDJPY exchange rate prevailing at the start of the 1970s, and cumulatively going forwards. Further detail available on request.

Have rate differentials returned as a driver of JPY returns? Since Covid, dollar-yen has broadly moved in line with the US-Japan real yield differential. BC, it didn’t. Figure 3 is your staple, *fiddle with the axes, put one line on top of another and see how nicely they match up* chart. Or not. However, in this instance, I do think even a simple analysis like this makes a serious point. Uncovered rate parity models can be viewed as another form of PPP, but where the ‘good’ in question is capital. There is therefore the same elegant logic as to why the force should be kept in balance, at least over the long term. Why then does there seem to be the step change at least optically illustrated in Figure 3?

One idea is that rate differentials were less important in a world where both absolute rates and rate differentials were lower, and where the volatility of the latter was also less. It was just less visible, so we all paid less attention to it. And indeed, comparing the periods in the left and right panels of Figure 3, average US real rates doubled from 0.3% to 0.6%, the mean differential between US and Japan rose from 72 to 112bps, and the standard deviation in the differential changes went from nine to 13bps.

One swallow does not a summer make. And indeed, looking at the correlation between the percent change in the real yield differential and the same for the exchange rate, while the sign does change from negative to positive between the two time periods in Figure 3, the magnitude of both is very small. But in the historically unusual environment where the Bank of Japan (BoJ) is hiking rates while the Federal Reserve (Fed) cuts, the potential continuation and intensification of this pattern is something I’m going to be watching closely. Moreover, one school of thought says that the BoJ is more focused on yen and Japanese government bond (JGB) volatility, than with any particular level. If that’s right, then Figure 1 could ultimately exacerbate the division with the Fed. We’ve taken the big step of negative to positive base rate and, in the context of long-term history, the gyrations haven’t been THAT bad. We go again, and don’t spare the horses.

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Another question that’s up in the air is whether JPY is still the safe haven to own in a global risk-off episode. Each segment on the x axis of Figure 4 is a period where the S&P 500 Index drew down by 10% or more from its local peak. The aqua blue bars are the total return you would have felt through that time going long JPY short USD. Pink is the same but instead of being long JPY you are buying an equal weighted basket of other DM currencies. Navy blue circles are the difference between the two. Those are positive 70% of the time and by an average of 3.5%. On this same basis, the yen enjoyed a particularly good run in the 10 episodes from the Global Financial Crisis to the end of 2020, where it was always positive, with a median difference of 11%.

So far, so good. However glancing through Figure 4, one is left with an unease that when a sell-off has an inflationary tinge to it (1973-74, 1979, 1980-82), or a bubble unwind aspect (2000-02), or indeed both (2022), the risk hedge wavers. Now my view is that the next risk-off move is likely to be a conventional, and relatively moderate, economic slowdown. Somewhere between Orthoclase and Quartz kind of landing on a Mohs Hardness Scale.¹ But equally, we are in a world where Tech is at least richly hyped, even if not in a bona fide bubble, and where many structural inflation drivers arguably remain in place.² The dynamic, in other words, is toward more unpredictability in how the classical JPY rules-of-thumb might operate, greater potential for strange (bad?) behaviour.

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A final metric for the dashboard is the correlation between JPY returns and the relative performance of Japanese equities. People often talk of these two variables being negatively correlated. In other words, Japanese stocks outperforming when the yen is weak, due to the export-oriented nature of the TOPIX. Figure 5 suggests this mental shortcut is likely too crude. TOPIX outperformance, more often than not, comes with JPY strength.

It is, however, true now. The current inverse relation between currency and equity relative returns is as negative as it’s ever been in the 30+ years shown in the chart. Today possibly bears some echo of former Prime Minister Junichiro Koizumi’s neoliberal reforms in the early noughties, where a manufacturing boom drove the currency and the market up together. The more recent pattern of economic activity -- the deflationary fears (often realised) that have dogged corporate Japan -- is one where a stronger yen potentially heightens depression concern, via downward price pressure on imports as well as a translation effect. Possibly this is the driver behind the periods of positive relation in Figure 5. My near term view is that the yen is currently so weak, as already discussed, that it can strengthen without continued adverse impact on the stock market.

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The yen is cheap. It is probably more responsive to rate differentials than it was. And in a world where divergence between central banks is becoming less unusual, it’s probably still a safe haven. But this is less predictable in a world of greater structural inflation and a richly valued Tech sector. It is currently moving highly inversely with TOPIX outperformance, but the continuation of this pattern is not a given.

In short, unpredictability is on the menu. And this is being exacerbated by some pretty punchy positioning. I have mentioned the infamous yen carry trade only in passing, because enough ink spilled, but it seems uncontroversial that this has led to one of the most rapid reversals in hedge fund positioning (from max short to slight long) ever seen (Figure 6). Meanwhile, in real money world, the latest BAML fund manager survey (220 respondents covering US$590 billion of AUM) has a net 40% reading saying JPY is undervalued, a high point going back to the questionnaire’s inception in 2005.

Strange times, in sum. For me, there’s a decent argument for unhedged Japanese equities. But expect turbulence.

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1. See:https://www.man.com/maninstitute/road-ahead-rock-solid
2. See here for my original discussion on these, a lot of which remains relevant, in my view: https://www.man.com/maninstitute/inflation-regime-roadmap