Yank's and Samurai's... Oh My.

The simple decision process for the Yen/Dollar.

The easy thing with exchange rate markets is that, at any one time, they tend to have one key driver. The challenging bit is that this key driver, be it valuations, interest rate differentials, differences in the returns on invested capital, geopolitics... Can change brutally from one day to the next. Having said that, when it comes to the JPY-US$ exchange rate, historically, the combination of three factors have given decent signals:

1. Differences in short rates: If short rates decline faster in the US than in Japan, the Yen rises, and vice versa.



2. Valuations: Then the Yen is one standard deviation undervalued on a purchasing parity basis, it will have a hard time going down, even if the movements of short rates play against it.



3. The cycle: When Japan moves into a recession, imports will fall. Since 65% of Japanese imports are paid for in US dollars, the demand for dollars will thus go down, dollar inventories held by importers for their working capital needs will be reduced and the Yen will tend to rise.
   
   

The challenge is to then combine these three sometimes conflicting forces. For example, in 2007 interest rate movements should have led to a fall in the Yen, but by then, it was already undervalued. It was not until 2008 that all the stars were aligned for the Yen to go up: narrowing short term interest differentials, no more overvaluations and a negative economic cycle. The Yen duly shot up.

So what happens next? Looking forward we feel confident that:

• Short rates will rise in the US long before they rise in Japan.



• The Japanese economy is moving out of its recession, partly thanks to the rebound in Asian and US growth. This means that Japanese companies are back to needing more US$ for their working capital.



• The Yen is today very close to overvalued territory.
  
  

Looking to Japan as a bellwether for recovery and growth, in relation to the US and it's larger trading partners, is an interesting and lucrative macro strategy that should be paid attention to going forward. Especially looking into other Asian Tigers for signals of future currency relationships between the East and the West.

(Comments from GaveKal's - Five Corners - Asia. Apr 12, 2010)