Japanese Yen, ‘Cheapest’ Currency Among G10

Implied volatility on the Japanese yen has been surging in recent weeks following BoJ dovish comments last month. Not only the BoJ has not expressed any interest in normalizing its policy despite the surge in inflation globally, the central bank recently offered to buy an unlimited amount of 10Y JGBs at 0.25% to limit the upside retracement in LT bond yields. As a result, the strong divergence in monetary policy between BoJ and other DM central banks (particularly the Fed) has led to a significant rise in USDJPY.

USDJPY broke above its 125.80 resistance (the high reached in 2015) to reach a high at 129.37 on Tuesday, and is now the worst performing currency among the DM world, down over 10% against the greenback since the start of the year.

JPY is now the most undervalued currency among the G10 world, currently trading 21.3% below its ‘fundamental’ value, which is estimated based on a BEER FX model using the terms of trade, interest rate and inflation differentials as explanatory variables.

Even though the yen appears as a ‘cheap’ currency to buy at the moment, MP divergence could continue to weigh on JPY in the near term. In the past cycle, the last two bullish trends on USDJPY driven by strong MP divergence saw an upward retracement of 20 to 25 figures. Hence, USDJPY could increase to at least 135 (start of the trend at 115), which represents a strong resistance (135 was the high reached in February 2002).

Figure 1: G10 FX Spot Rates vs. ‘Fair’ Value

Source: Reuters, RR

AUD, GBP Most Undervalued In G10 World

In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.

AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.

The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.

On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.

Source: Bloomberg, RR calculations

Great Chart: Oil Prices vs. Japan Trade Balance

The recovery in oil prices since February 2016 has eased financial conditions for most of the Middle East countries and has reversed the path of the corporate default rate for US energy companies exposed to the shale industry. Higher oil prices have also brought back inflation in most of the economies, hence pushed up expectations of nominal growth rates. However, for countries that are heavy importers of energy (i.e. Japan), higher oil prices usually mean a deterioration of the Trade Balance. Japan has limited domestic proved oil reserves (44 million barrels), which means that the country is a net importer of oil. According to the EIA, Japan is the fourth-largest petroleum consumer and the third largest net importer, and its daily consumption in 2016 was of 4 million barrels per day. Therefore, if we plot the WTI futures prices (6M lead) with the Japanese trade balance, we can notice a significant co-movement between the two times series. This chart suggests that oil prices can be used as a sort of leading indicator for the Japanese trade balance. For instance, when oil prices entered a bear market in 2014, the trade balance switched from a 1.1tr JPY deficit in the middle of 2014 to a 350bn JPY surplus in H2 2016. Hence, with oil prices constantly trending higher with the front-month contract on the WTI trading at $70 per barrel, its highest level since Q4 2014, we can potentially anticipate that the Japanese trade balance will go back into deficit in the medium term.

What are the consequence for the Japanese Yen?

In our BEER FX model, we saw that exchange rates (in log terms) react positively to a positive change in interest rate differential and in terms of trade differential, and negatively to a change in inflation rate differential. Hence, if we expect import prices to rise in Japan due to higher energy costs (especially Oil), the terms of trade should ‘deteriorate’ and therefore have a negative impact on the currency. However, we know that the Japanese Yen is also very sensitive to the current macro environment and often acts as a safe-have asset when the risk-off sentiment rises (Yen appreciates in periods of equity sell-off). In our view, the problem Japanese officials may face in the following 6 months is higher energy prices combined with a strong Yen at 105 (vis-à-vis the US Dollar), which will directly weigh on the country’s economic outlook as fundamentals will start to deteriorate, leaving less and less room for some BoJ manoeuvre.

Chart: Oil prices (WTI, 6M Lead) vs. Japan Trade Balance (Source: Eikon Reuters)

Japan Trade