The Yen Is Priced For Equity-Like Returns

Summary

• The Japanese yen looks set for equity-like gains over the next 12-24 months after recent weakness has left the currency deeply undervalued relative to fair value.
• Despite the recent rise in U.S. real yields, USDJPY remains far higher than real bond yield spreads suggest it should. Based on historical correlations, USDJPY should be trading around 100.
• The Japanese yen is also remarkably cheap in real effective terms thanks to FX gains for Japan's main trading partners and Japan's much lower inflation rate.
• The USDJPY chart pattern suggests that the trend of lower highs since the 2015 peak remains intact. The pair is currently testing the 110 level and a close below here would suggest that a reversal pattern is taking place.

Photo by Osamu Takeishi/iStock via Getty Images

The Japanese yen looks set for equity-like gains over the next 12-24 months after recent weakness has left the currency deeply undervalued relative to fair value on a number of metrics. Technically, USDJPY looks to be posting another lower high, suggesting the yen bull market from the 2015 highs remains intact.

Short-Term Fair Value Model Suggests Yen Below 100

The Japanese yen has tended to be driven by changes in U.S. real bond yields relative to those in Japan. As the chart below shows, despite the recent rise in U.S. real yields amid the rise in rate hike expectations, USDJPY remains far higher than real bond yield spreads suggest it should. Based on historical correlations, USDJPY should be trading around the 100 level, a full 10% from current levels.

Source: Bloomberg, Author's calculations

Deviations between USDJPY and the fair value level implied by real yield spreads have shown a strong tendency to drive changes in the currency pair over the following two years. The current real yield spread suggests that the yen will see around 15% gains over the next two years. Note that this is higher than the current 11% difference between USDJPY and fair value as the currency pair has shown a tendency to overshoot following similar periods of undervaluation.

Source: Bloomberg, Author's calculations

Real Effective Exchange Rate Also Deeply Undervalued

The Japanese yen is also remarkably cheap in real effective terms. Real effective exchange rates differ from nominal exchange rates in that they take into account inflation as well as the performance of the country's main trading partners. A combination of a weakening yen, FX gains for Japan's main trading partners, and Japan's much lower inflation rate relative to its peers, the yen's real effective exchange rate is close to its weakest level in decades. This strongly suggests that the yen is undervalued, and over a multi-year perspective, this should translate into upside pressure on the currency.

Japanese Yen Real Effective Exchange Rate

Source: JPMorgan, Bloomberg

Trend Of Lower Highs Remains Intact

The USDJPY chart pattern suggests that the trend of lower highs since the 2015 peak remains intact. The pair is currently testing the 110 level and a close below here would suggest that a reversal pattern is taking place.

USDJPY Exchange Rate

Source: Bloomberg

Another positive technical signal for the yen is the recent recovery in gold prices. The yen has been closely correlated with gold prices over recent years as both assets tend to be driven to some extent by U.S. real interest rate changes. Gold's recovery of the USD1,700/oz level is therefore a positive signal for the yen.

JPY Versus Gold

Source: Bloomberg

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.