If you are looking at what could be the most glaring price anomaly on the planet, it is the Japanese yen. It hit its worst level in over three decades in July at 161 yen and has since moved to 145 yen, and this story is not over yet. (The currency is valued here against the greenback, and a lower figure represents yen strength and U.S. dollar weakness.)
The currency has absolutely no reason to be as low as 145 yen. The central bank is bucking the global trend by raising rates and pledging to continue doing so. (Currencies respond most to changing interest-rate differentials; rising interest rates in a country prompt investors to buy, which drives up their value.)
Despite the recent slide in the stock market in the aftermath of the most recent Bank of Japan hike, it has staged a comeback, and the Japanese government just raised the economic outlook there for the first time in 15 months. The impact of the ultraweak yen has been brutal – triggering a 4.3-per-cent year-over-year boost to unit labour costs, taking them to a four-year high.
This surely cannot be lost on the central bank. And the pressures on import inflation from the past year’s rapid yen descent have pushed the year-over-year trend to a whopping 10.8 per cet. A country with a near-record high current account surplus-to-GDP ratio of 1.1 per cent has absolutely no business being in a bear market.
What has caused the slide in the yen has been the financial repression engineered by the BoJ, but that phase has now come to an end – first through forex intervention by the BoJ to buy up yen and drive it higher, and second by rate hikes that are far from over.
There are two powerful forces at play: tighter BoJ policy versus an easier Fed policy (eradicating the leveraged yen-carry trade, which sees investors borrow at a lower interest rate to invest in a currency with a higher rate of return), and Bob Farrell’s classic market Rule No. 1 on the simple concept of mean reversion. Ratios, not levels, revert to long-term means.
The yen, as with most currencies that freely float, does revert to the mean. In this case, the long-run mean is 113 yen, which means there is more than 20 per cent left in the tank as far as yen appreciation potential is concerned. But as we all know, mean reversion, by definition, means moving through the mean in both directions and correcting one excess often requires an extreme move in the other direction. So what could that mean? A likely 40-per-cent appreciation – which is totally consistent with the Economist’s Big Mac Index (the publication’s well-known comparison of the cost of a Big Mac around the world) – which shows the Japanese yen at the current time to be undervalued by 44 per cent.
In this business of financial forecasting and investing, there is never such a thing as a sure thing. Playing the shifting probabilities and understanding the risk of being wrong benchmarked against the reward of being right are the hallmarks of success.
Let’s split the difference between the mean and the Big Mac Index and what it says is that for you to earn 30 per cent for your clients (or yourself) in the coming year or two, all you need to do is ride the tailwind of the unwind of the yen bear market – a 30-per-cent potential return here without taking on equity risk and without taking on duration risk. Just invest in Japanese money market paper (who cares if it’s a 0.3-per-cent yield – you’re not embarking on this strategy for interest income, but for the vast currency appreciation).
Also new from Rosenberg Research: Defence stocks are still an attractive option for your portfolio
David Rosenberg is founder of Rosenberg Research
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