Yen uptrend is over – Deutsche Bank

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Deutsche Bank has abandoned the bullish stance on the yen it has held since the onset of the financial crisis in late 2008.

The bank has revised its forecasts to show a turn in the medium-term trend in USDJPY.
“We expect that the turn will start to become apparent this year, but will gather momentum in 2013,” says Bilal Hafeez, head of FX strategy at Deutsche.

Reflecting that, the bank revised its forecast for USDJPY from ¥75 to ¥82 by the end of the year and from ¥85 to ¥90 by the end of 2013.

Hafeez says a paramount part of the revision is the belief that the market has already seen the valuation extreme for USDJPY in the current cycle.

Historically, USDJPY has fallen to around 20% below purchasing power parity (PPP) before finding a medium-term base. Only in 1995 did it move to more extreme levels, with a 40% drop.

Hafeez says judging whether the current downtrend in USDJPY was more like a regular 20% overshoot or a more pronounced 40% move has been the big challenge since 2008.

“Our sense is that a 20% overshoot is the more likely limit for USD/JPY in the current cycle,” he says. “This in turn suggests that breaching last year’s low of ¥75 may be possible, but is unlikely to be enduring.”

USDJPY typically overshoots to 20% undervaluation

 Source: Deutsche Bank


Hafeez cites three reasons why that might be the case.

First, mean reversion from valuation extremes in USDJPY tends to be the result of intervention, and last year’s record intervention from the ministry of finance and the Bank of Japan (BoJ) could well be a catalyst for such a move.

Intervention at valuation extremes works better

 source: Deutsche Bank, EcoWin
Second, the strength of the yen has had a marked impact on Japan’s trade balance – a sign that a valuation extreme has been reached.

Third, Japan’s terms of trade have been deteriorating, in contrast to 1995. That implies the yen’s real equilibrium value should be weaker. Indeed, Deutsche says incorporating terms of trade and productivity in a behavioural equilibrium exchange model suggests the yen is the most overvalued currency in the world.

Away from valuation, Hafeez cites a pick up in the breadth and pace of monetary easing in Japan as another reason why USDJPY is set to turn. This was prompted not just by the series of shocks that Japan endured after the earthquake in 2011, but also by an increase in political pressure on the BoJ to stem the rise in the yen and fight deflation.

Frequency of BoJ actions is increasing

 Source: Deutsche Bank, EcoWin


In addition, the prospects for US monetary policy also point to a turn in USDJPY, says Hafeez, with the reduced willingness of the Federal Reserve to increase its balance sheet supporting the currency pair.

Finally, Hafeez highlights the falling correlation of USDJPY with US stocks and US bonds, which points to the fact the yen is losing its safe-haven status.

“All the above suggests the major downtrend in USD/JPY is behind us,” he says. “There could still be bouts of yen strength, particularly in the near-term, but we believe the trend is in the midst of turning.”