Stephen L. Jen of Morgan Stanley (MWD) - London, penned a piece last Friday that I have to agree with, "My 'Line in the Sand' is 125," in reference to the yen-dollar exchange rate not likely exceeding 125. I don't believe the rate will exceed 125 unless post-April 1st at the beginning of the new fiscal the BoJ mishandles its monetary policy. I expect a yen correction next year in addition to further gains on the Tokyo Stock Exchange. Call me overly optimistic but be sure you read Jen's piece below and also check out Roach's piece below this post.
Hedging needs could power a USD/JPY overshoot
I see modest further upside to USD/JPY, which is entering overshoot territory. While USD/JPY could still test 125, from a fundamental perspective, it should not trade much higher.
My basic story for USD/JPY’s rise remains unchanged
Cash yield differentials do not always dominate USD/JPY. Back in 2001, the Fed-BoJ policy rates were around 6% apart, yet USD/JPY was declining. They are important now because they arose against the backdrop of a global equity market that was out-of-balance in terms of its currency hedging. Specifically, equity investors were running a large implicit underweight position on the USD by under-hedging against the USD, reflecting the structural USD bearishness that saturated market sentiment late last year. When the Fed continued to hike rates this summer, however, the cash yield differentials, which matter most for hedging purposes, began to act as a tax on these equity investors. The subsequent rise in USD/JPY, then, exacerbated the situation as it acted as a second tax on equity investors. In response, as more equity investors raised their hedge ratio on their JPY exposure, USD/JPY rose, which in turn forced more hedging. At the same time, Japanese exporters hedged at around the 103-104 ‘budget rates’. Continued Fed tightening and the resulting up-drift in USD/JPY forced them to reduce their hedge ratios. These dynamics are not ‘self-correcting’. Rather, they are ‘mutually re-enforcing’. This is why USD/JPY has been so energetic in the second half of this year.
Further hedging by foreign investors
When we talk about the ‘hedge ratio’ of foreign (USD-based) investors, we tend to think of the denominator as the USD capital invested in Japan’s equity markets. In practice, however, it is the Nikkei exposure in JPY that is hedged. This is one way through which USD/JPY and Nikkei could be positively correlated.
In the piece I wrote last week, I also suggested an arbitrage condition (Uncovered Equity Parity Condition) which could also explain this tight relationship between the relative equity market performances and USD/JPY. If we believe that this relationship will continue to hold, the performance of the Nikkei relative to the S&P will be key.
It is likely that the hedging positions will adjust further. Already, the cash yield premium has converted many structural USD bears into USD bulls. I think this process is not complete. The rising cost of not hedging will force USD/JPY marginally higher. This process will stop only when the Fed stops.
Downside forces are mounting, however…
1. USD/JPY is already over-valued. USD/JPY is increasingly mis-priced, in my view. The median fair value (FV) from our valuation framework, as of end-2Q, was 106. I should underscore that, in terms of standard deviations away from USD/JPY’s fair value, we are still not in dangerous territory, i.e., valuation itself is not likely to be the key driver keeping USD/JPY from rising further.
2. Japanese investors could be tempted to increase their Nikkei exposure at the expense of buying foreign bonds. If the Nikkei remains supported into the new fiscal year, it would be surprising if Japanese retail and institutional investors do not consider increasing their exposure to the Nikkei.
3. Nikkei is already flirting with bubble territories. Our Japanese Equity Strategist, Kamiyama-san, believes that, from a current valuation perspective, a further rally in the Nikkei can no longer be justified. Since May, N-225 has rallied by more than 40%. If the Nikkei stalls and stabilises, USD/JPY should also stabilise as hedging abates.
4. Cash yield differentials to gradually lose their dominance. While cash yield differentials will continue to influence the cost of hedging, if and when equity investors achieve their desired hedge ratios, the impact of further rate hikes on USD/JPY should abate.
5. The real economic fundamentals of Japan continue to improve. In my note on USD/JPY and Total Factor Productivity (TFP) growth, I argued that the potential overshoot in USD/JPY should be contained partly because TFP growth has accelerated since 2002.
…But a sharp collapse in USD/JPY is not likely, either
If USD/JPY sags lower, I see the move limited to 117 or so. A sharp fall toward 110 looks very unlikely, particularly if the Fed continues to tighten. It would just be too expensive to short USD/JPY, and too expensive for real money investors to forego this meaningful yield pick-up.
There will be no intervention by the MoF to cap USD/JPY
USD/JPY is up here not because of interventions, but because of market forces instead. I do not think the MoF will intervene.
From an economic perspective, USD/JPY should not rise further. But from a Fed/hedging perspective, a modest further increase looks possible. My ‘line in the sand’ is 125.