04.21.22: Economies are like battleships: they tend to move slowly and deliberately. Abrupt directional changes, in markets or policies, tend to upset them. For example, in the late 1990s a series of currency declines set off the Asian Contagion and pushed several Pacific Rim economies and markets, like those of South Korea, Indonesia and Thailand, to the brink. The sudden implosion of the US housing bubble in 2008 prompted a global financial crisis, which led to the bankruptcy of Lehman Brothers and to shotgun marriages of brokerage firms and banks. Today, Japan is facing the abrupt policy shift of other developed market bankers who found themselves behind the inflation curve, while it, in effect, has shifted into reverse. Does the plunging Yen present opportunities, or further risks, to investors?

Last fall, central bankers viewed elevated inflation rates with dry disengagement, believing inflation was transitory. By year-end 2021, the Federal Funds rate was nearly seven percentage points below the inflation rate, a record. Yet, inflation kept rising. Chairman Powell’s whiplash-inducing about-face on interest rates ripped through the bond market, launching rates on their highest trajectory in 40 years and forcing other central bankers to get onboard. The Fed has already hiked the overnight rate by 25bps and investors are bracing for two consecutive 50bps hikes at the Federal Open Market Committee’s May and June meetings.

Graph 1, Market Update, 4.21.22

But the Bank of Japan (BoJ) has bucked the global trend, in effect doubling down on its easy money policy this week by unexpectedly announcing bond purchases. Japan’s inflation expectations are very low: the 5-year inflation rate, five years out is expected to remain below one per cent, largely due to the country’s rapidly aging population and lackluster consumer demand. The BoJ’s policy divergence from the rest of the developed world, however, has weighed on the Yen, pushing the currency into its longest losing streak in at least 50 years. At 128.46 JPY/USD, the currency stands at its weakest level since 2002, according to Bloomberg. Aside from some tough talk, however, BoJ has not intervened to stem the Yen’s decline – and its recent reaffirmation of its loose monetary policy is quite the opposite. Japan’s currency erased about 10 per cent of its value against the USD over the last six weeks.  Graph 2, Market Update, 4.21.22

Such an abrupt decline will undoubtedly have a negative impact on the Japanese economy by raising the cost of imported goods that companies will struggle to pass on to their customers. The Japanese Nikkei-225 has lost about eight per cent in USD terms since the Yen slide. The Bank of Japan has periodically intervened to support the Yen, but the last time was 1998 in response to the Asian Contagion. Japanese government officials are concerned that continued Yen weakness could spark a domestic economic crisis and are pressuring BoJ Governor Kuroda to do something.

Graph 3, Market Update, 4.21.22

While we understand the catalyst, we believe the recent Yen selloff is overdone, fueled by carry-trade investors who borrow yen at a slightly negative yield and pick up over 2.5 per cent investing in dollars.  The popularity of the carry-trade strategy puts immense pressure on the Yen in the near term.

It is important to bear in mind that currency fundamentals are a function of four factors: relative interest rates, relative inflation rates, trade balances and relative economic growth. The Yen has historically been a haven currency, rising when investors become fearful. In fact, the Yen is remarkably cheap from a purchasing power parity (PPP) basis, an approach like the Big Mac Index. Take the USD price of a Big Mac, translate that value into Yen, and see if you could purchase a Big Mac in Japan. According to our analysis, you could buy more than two Japanese Big Macs with the dollars it costs to buy a Big Mac in the United States. Our work evaluates a basket of comparable goods between the US and our trading partner countries, not just Big Macs.  In our view, Yen fundamentals will eventually outweigh today’s negative technicals. 

We expect an overly aggressive Fed, in its quest to quell inflation, to dent the US economy, which would prompt a rollover in inflation and growth. We’re already seeing evidence of slowing in rate-sensitive areas of the economy like housing and automobiles. We expect US rates to decline later this year or early next year, prompting relative USD weakness. That environment would likely usher in foreign equity market outperformance, including Japan’s Nikkei-225.

Image 5, Market Update, 4.21.22