Can the yen recover on its own or is it all a fantasy?

The fall of the Japanese yen is becoming one of the biggest macro stories of 2022, with the currency losing 11% against the US dollar and reaching levels last seen more than 20 years ago. But with everyone betting big against the yen, is it time to buck the trend and buy the dip? Let's take a look.

Why has the yen fallen so much these months? 

The entire situation that has unfolded over the past few months with the conflict in Ukraine has caused the yen to be affected for several reasons: Investors are simply withdrawing their money from Japan . This is because, while interest rates are rising considerably in almost every other country, they remain at record lows in Japan. This is due to the Bank of Japan (BoJ) implementing an even more extreme version of quantitative easing called "yield curve control" (YCC) . It involves not only keeping short-term rates low but also explicitly capping long-term rates . Since investors can earn much higher returns on their investments elsewhere, they are fleeing Japan, which increases selling pressure on the currency.

Now, even without yield curve control in place, it's worth noting that Japan's economy is in a very different place than the rest of the G7 countries: its economic growth is much lower and its inflation much more moderate, given Japan's years-long battle against deflation. That has led investors to place a very low probability on any change in the Bank of Japan's policy, creating a one-way bet against its currency. Moreover, extremely low interest rates have made the yen the preferred funding currency for carry trades . These are popular foreign exchange transactions in which investors sell the yen against higher-yielding currencies like the Australian dollar, allowing them to profit from the yield differential between the two.

And since they are selling the yen, the value of the currency has been falling lower and lower. Speculators and trend followers have further exacerbated the decline: by jumping on the bandwagon to profit from the yen's decline, they have pushed the currency faster to the bottom.

Has the yen fallen too much, too fast? 

It's a posibility. The yen's decline has been steep and has fallen against several currencies, not just the US dollar. And its current real effective exchange rate (REER), the currency's value against a weighted average of its major trading partners, is nearly three dollars' deviation below its recent average. That suggests prices may have surpassed their fundamentals and increases the odds of a rally.

The yen is also considered the most undervalued G10 currency against the dollar, based on its "purchasing power parity," a measure of how much a country's currency can buy. However, valuation alone is not a sufficient reason to make an investment. But with the yen so low, I can't see too many scenarios (aside from skyrocketing US interest rates) that would cause the yen to weaken further. In fact, I would say that the balance of risks is changing.

Why might the yen rise? ‍♂️

There are several reasons why the yen could be close to an upward move: (i) First, markets may be underestimating the risks of a policy change. Sure, a weak yen can be positive for the economy, but not if it weakens too much. If inflationary pressures reduce consumer spending or corporate profits too much, there will be more pressure for the Bo to reverse course on its ultra-accommodative monetary policy. And that could take two forms:

• The BoJ could relax your yield curve control program raising the yield level or changing the maturity of the bonds it targets.
• The Ministry of Finance could intervene in currency markets directly, as a higher yen would be another way to fight inflationary pressures.

The market wouldn't even need to see decisive action for the currency to react: an accelerating pace of this narrative should be enough to put a floor under the yen. (ii) Second, it doesn't look like US bond yields and commodity prices will continue to rise at the same rate . In fact, risks to economic growth are clouding their outlook. That will mean less pressure on the Federal Reserve to raise interest rates aggressively , making US assets less attractive . Even a pause in the rally in yields and commodity prices would likely be enough to trigger a relief rally for the Japanese currency.

(iii) Third, the yen's technical aspects could accelerate a favorable turnaround. Investors may begin to take profits at current levels, and longer-term value investors may start to emerge. This will restore some balance between supply and demand and help stabilize the currency . Furthermore, a more uncertain macroeconomic environment is likely to increase volatility, making life more difficult for higher-yielding currencies and potentially forcing investors to close their carry trades. Finally, the yen is currently trading near key support levels against the US dollar, which should provide some support for the currency.

And how can we take advantage of this situation? 

Initially, we can buy the Japanese yen , which seems like an attractive opportunity in the medium term, given that the coming weeks could offer some juicy entry points, boosted by a Bank of Japan meeting and some important economic data releases . But which currency should you sell to buy the yen? The cleanest option would probably be to sell a basket of Asian currencies , although that can be tricky to execute. Shorting the US dollar also makes sense: the dollar is one of the most overvalued currencies out there and the easiest and cheapest to trade.

If, on the other hand, we have a bearish view of the global economy, or want to use the trade as a portfolio hedge against a recession, we could also consider selling higher-yielding currencies like the Australian or Canadian dollar —a trade that should pay well in a risk-averse environment. We can execute the trade through the spot market or using derivatives such as contracts for difference (CFDs). If we only want to trade stocks and lack prior investment training, our options are more limited, but there is an ETF that allows us to gain exposure to a stronger yen against the dollar: the Invesco Currencyshares Japanese Yen Trust (FXY) . However, it has a fairly high fee (0,40%), so it may not be a great long-term option.