“The Yen has excessively weakened against its long term real effective exchange rate during “risk-on” periods, as Japan has embarked on tremendous overseas carry trades (providing debt to emerging markets). This trend tends to reverse swiftly during “risk-off” periods as the debt goes sour. The Yen looks 25% too cheap, with potentially a long way to strengthen yet.”
A nation’s currency should primarily adjust around its relative inflation rate, with high inflation offset by a depreciating currency. The Bank of International Settlement’s (BIS) nominal effective exchange rate (NEER) data below shows two currencies that have significantly devalued in nominal trade weighted terms over the last two decades. Meanwhile the inflation adjusted real effective exchange rates (REER) have oscillated around their long term averages. If currencies didn’t adjust for inflation then a Caipirinha in Rio or Kebab in in Istanbul would become impossibly expensive for the rest of us … as would the local labour markets.
The reverse is true for low inflation countries like Japan, whose currency should appreciate against higher inflation trading partners over the long term. Currencies can get out of kilter during debt up-cycles as asset imbalances build during “risk-on”. This century the Yen has excessively weakened against its long term REER during “risk-on” periods, as Japan has embarked on tremendous overseas carry trades (providing debt to emerging markets). This trend tends to reverse swiftly during “risk-off” periods as debt goes sour. The Yen looks 25% too cheap, with potentially a long way to strengthen yet as emerging markets struggle.
Japan is the only major economy this century to consistently see an appreciation of its currency during a debt crises. This amplifies Japan’s cyclicality and it is not surprising that Japanese equities fall more than other markets during “risk-off”. It appears that Japan is heavily involved in emerging market debt, where the crises and outflows may have only just begun. Conditions are in place for a sustained “risk off” with global debt levels at record highs and negative OECD leading indicators. Japan is the ideal market to be short of for amplified returns in a down turn. P.S. Many of you will probably be thinking, “won’t Japan will just do more QE?”. I remain of the view that Japanese QE does not actually increase money supply as the vast majority of “liquidity” created just ends up being placed back on overnight deposit at the Bank of Japan or stuffed under the mattress. Japan is also near the limit of its bond purchasing program as outlined in my previous note Japanese QQE Costs And Side Effects. It is most interesting to see that since this note, Japanese bond yields have displayed characteristics of an asset class in severe shortage and cash hording has accelerated. The Bank of Japan Governor Kuroda recently stated “I don’t have plans for further monetary easing at the moment” (Link: Reuters 14 Jan 2015). With inflation rates dramatically underwhelming this must imply he and/or a majority of his board also feels that Japan Government Bonds purchasing has reached its limits. The markets realisation of this could see a rapid unwinding of the short Yen / long Japanese equities trade, this flow would amplify returns in shorting Japan.