Forex Investment and Currency Trading

The outbreak of the credit crisis has helped to boost the trade-weighted Japanese yen (JPY). While interest rates remain at ultra-low levels, it will be difficult for the JPY to rally much further on a tradeweighted basis. However, against the USD, the yield differential has narrowed substantially. The carry trade has been a major factor for the JPY. Japanese institutional and retail investors are expected to continue to put money into higher-yielding assets abroad. The latest anecdotal evidence is that the appetite for this is currently low given the risk of investing amid the current global turmoil. Longer term, these flows may continue to be a dampening factor for JPY appreciation.

However, as the USD continues to fall against the majors, the JPY is likely to benefit. EUR-JPY is expected to bottom out around 147 in early 2009 before a resumption of EUR out-performance, driven more by growth and yield differentials. Estimate of fair value for USD-JPY is 114.70. Note that the OECD estimate of PPP for USD-JPY has been declining for decades. As of 2007 the OECD’s fair value based on PPP was 121.0, down from 143.7 in 2002.

There are two factors that should be gradually supportive for the JPY. Firstly, anecdotal evidence suggests that Japanese institutional investors have become much more wary of buying foreign bonds recently. Secondly, interest rate spreads are expected to narrow further as the BoJ continues the very gradual hiking cycle while others (in particular the U.S.) continue to ease.

With the JPY REER just off 20-year lows, the longer-term outlook appears to be an easier call than the short term outlook. While portfolio outflows are currently dwarfing the current account surplus, such extreme JPY undervaluation should provide significant support for Japan’s trade and current account balances on a multiyear basis. Moreover, it seems reasonable to expect more USD weakness against Asia over the longer term than the EUR given relative valuation.