Summary
- USD/JPY has reached new highs but we would be cautious chasing it higher.
- While the rise in US yields is helping USD/JPY, the US 5s30s curve needs to flatten even further for more USD/JPY upside.
- On valuations, we find USD/JPY is close to the most expensive it has ever been.
- Japan continues to run a current account surplus thanks to its large income balance, which is less sensitive to USD/JPY moves.
- Looking at correlations, yields appear to the dominant driver of USD/JPY, but risk markets and the broader dollar trend are also important.
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Summary
- USD/JPY has reached new highs but we would be cautious chasing it higher.
- While the rise in US yields is helping USD/JPY, the US 5s30s curve needs to flatten even further for more USD/JPY upside.
- On valuations, we find USD/JPY is close to the most expensive it has ever been.
- Japan continues to run a current account surplus thanks to its large income balance, which is less sensitive to USD/JPY moves.
- Looking at correlations, yields appear to the dominant driver of USD/JPY, but risk markets and the broader dollar trend are also important.
USD/JPY recently touched 121 – its highest level since January 2016. All the yen weakness has occurred over the past two weeks has coincided with an alleviation of Russia-Ukraine war risk premia and ramping up of Fed hike expectations. These dynamics caught me by surprise, but I’m still reluctant to buy USD/JPY at current levels. If anything, I’ll be looking for the right time to sell USD/JPY. Here’s my reasoning:
(1) Yields Matter, But Not How You Think. For sure, the surge in US yields coupled with a dovish BoJ has helped spur USD/JPY strength. But the relationship between rate spreads and USD/JPY is unstable (Chart 1). USD/JPY jumped in 2014-2015 without rate spreads moving up. This was partly to do with Abenomics. Then in 2020, rate spreads collapsed without an associated large decline in USD/JPY.
There appears to be a closer relationship between USD/JPY and the relative yield curves. We find that when the US 5s30s curve flattens more than the Japan 5s30s curve than USD/JPY rises and vice versa (Chart 2). From a currency perspective, a flatter or inverted curve means the central bank is willing to drive long-term nominal growth lower in order to fight inflation, which is positive for the currency. Therefore, a bullish USD/JPY view is also US rates flattening view.
The trouble with this is that the US curve has already flattened significantly and is not too far from inverting (Chart 3). When a meaningful inversion happened in the early 1980s stocks tumbled as they also did in the early 2000s. Neither scenario would likely be bearish yen.
(2) USD/JPY Is Expensive. Relative to PPP, USD/JPY is now overvalued by 45% – this is close to the highest on record (Chart 4). Of course, deviations can be justified on a number of grounds. The clearest one today is that Japan is suffering a huge negative terms of trade shock with the rise in energy prices. Indeed, the relative terms of trade between the US and Japan is at its worst level on record. This has coincided with persistent overvaluations in USD/JPY. If we adjust PPP for terms of trade effects, then USD/JPY is only 10% overvalued.
However, on the flip side, real rate spreads also lead to deviations from PPP. And on that score, US real rates are close to their lowest levels on record (Chart 5). In theory this counters the negative terms of trade effect and would keep USD/JPY in extreme overvalued territory.
Therefore, USD/JPY valuations can only be maintained if energy prices stay high (possible) and short-term US real yields move firmly into positive territory. The latter would happen if the Fed was to maintain a hawkish path even if inflation was to fall to 2-3%.
(3) Japan balance of payments. While Japan has recently printed a negative current account balance number, on a twelve-month basis it continues to run a healthy surplus of around 2.5% (Chart 6). However, the larger question is on the mix of the current account. Since shutting its nuclear power in 2011, Japan has stopped running persistent goods trade surpluses. Instead, a growing income surplus is now the dominant component of the current account. This means that fluctuations in USD/JPY are becoming a less important driver of the current account. Correlations show that a rise in USD/JPY (yen weakness) typically leads to an improvement in the goods trade balance. Meanwhile, the correlations are much weaker between the income balance and USD/JPY.
This suggests understanding the behaviour of Japanese financial institutions, rather than exporters, is more important. Currently, while US yields have surged, the FX hedged US yield for Japanese investors has been falling (Chart 7). This could lead to Japanese investors reducing their hedge ratios to capture the higher unhedged yield, which would be bullish USD/JPY. Alternatively, Japanese investors could keep their hedges and invest any new cash into 30y JGBs which are yielding 0.94% compared to the FX-hedged US 10y yield of 1.04%.
Looking at portfolio flows, we are already seeing declining Japanese purchases of foreign bonds, which suggests a preference for domestic bonds (Chart 8). Instead, the outflows seem to be going into foreign equities as Japanese buying has picked up of late (Chart 9). This suggests global equity weakness could see Japanese repatriation and hence yen strength.
(4) Correlations. Finally, we look at market correlations with USD/JPY. Starting with interest rates, we find strong positive correlations between US yields and rate spreads and USD/JPY. The correlations are high whether we look at 2y, 5y or 10y (Chart 10). Meanwhile, on the yield curve, we find strong negative correlations on levels of USD/JPY rather than on changes. That is, USD/JPY’s trend appears to get affected by the 5s30s curve, rather than week-to-week moves.
Outside of rates, we find that on changes in USD/JPY, USD/CNH and US stocks are positively correlated. This means a stronger CNH and weak stocks are associated with yen strength. However, the magnitude of these correlations are lower than with yields. On negative correlations, we find changes in USD/JPY are correlated with high-yield spreads – so spread widening is associated with a stronger yen.
In terms of correlations between the level of USD/JPY and other markets, we find strong positive correlations with USD/EUR and oil. This suggests broad dollar strength and oil price rises affect the USD/JPY trend.
Overall, correlations suggest yields are a big driver of the yen – any stabilization in yields could USD/JPY fall. Moreover, correlations still suggest the yen acts as a risk-off currency.
Key Takeaways
USD/JPY has reached new highs but we would be cautious chasing it higher. While the rise in US yields is helping USD/JPY, the US 5s30s has already flattened significantly, so there could be less scope for a favourable move in the curve that would support USD/JPY. Then on valuations, we find USD/JPY is close to the most expensive it has ever been. Admittedly, the negative terms of trade shock Japan has experienced with higher energy prices could justify more expensive levels in USD/JPY, but equally low US real yields would suggest it would harder for USD/JPY to stay expensive.
On balance of payments dynamics, we find that Japan continues to run a current account surplus thanks to its large income balance, which is less sensitive to USD/JPY moves. The key portfolio flow to watch are Japanese purchases of foreign equities which have picked up of late. Finally, when looking at correlations, yields appear to the dominant driver of USD/JPY, but risk markets and the broader dollar trend are also important.
For now, our bias is to stay neutral on USD/JPY and look for a stabilization in yields, a turn in Japan portfolio flows, and equity weakness to play for USD/JPY downside.