Intervention: It’s been a while
The Japanese yen has been one of the weakest currencies in the world this year. It seems like only a few months ago we we wondered if the Japanese authorities would mind trading USD/JPY all the way to 115, only to see it touch 125 at the end of March. Driving the rally has been the perfect storm of a hawkish Federal Reserve, a dovish Bank of Japan (BoJ) and Japan’s negative terms of trade shock as a major importer of fossil fuels.
The move to 125 prompted remarks from Japanese politicians that they were watching exchange rates very carefully. More recently, BoJ Governor Haruhiko Kuroda called USD/JPY’s rise “somewhat fast”. But will this concern trigger intervention in the foreign exchange market to support the yen?
Japan’s last foray into the world of FX intervention was in late 2011 when it bought USD/JPY to support it near 75. The last time the BoJ sold USD/JPY (a rare event) dates back to June 1998 in the middle of Asia. crisis as USD/JPY traded at 145.
USD/JPY is not currently at any of these extreme levels, although the inflation-adjusted real exchange rate actually shows that the yen is weaker today than it was at the end. 1990s. In theory, then, the BoJ might have a reason to use intervention to support the JPY. But we think that’s unlikely, largely because of G20 communications and protocol issues.
Japanese intervention in the foreign exchange market has become the exception and not the rule
Why an FX intervention is unlikely
One of the first, and perhaps the only, objectives of FX intervention is that it must succeed. Not that we’ve seen a lot of FX intervention in the G3 FX space over the past decade, but successful intervention in liquid FX pairs should be coordinated. Involving the Fed in a sell dollar operation at a time when the Fed is about to raise rates by 300bp is highly unlikely. If any intervention were to occur, it would likely be Japan alone.
But as our chart above shows, which was more common in the 1990s and until about 2003, Japanese foreign exchange intervention over the past two decades has been the rare exception rather than the rule. As a member of the G20 and the tighter G7 group, Japan has had to adhere to flexible exchange rates – as a way to bring China into line with a less managed currency.
To justify proprietary FX intervention to sell USD/JPY, Japanese authorities would have to state forcefully that the weak yen was not just a Japanese problem but a global problem. In fact, it seems hard to argue that a weak JPY is even a problem for Japan. It certainly doesn’t look like the “sell Japan” mentality is developing – Japanese equities haven’t underperformed. And if the Japanese fear that soaring energy prices will be exacerbated by the weak yen, they can either raise interest rates or adopt fiscal support measures (a shield against inflation) rather than to intervene.
The only case we see of the Japanese Ministry of Finance ordering the BoJ to sell USD/JPY is the case of a disorderly currency movement. What is messy? This will depend on the speed of the move and the market conditions. In the past, Japanese policymakers have looked to the currency options market to judge market conditions. Previous interventions in the FX market for disorderly moves came as USD/JPY month-to-month volatility traded closer to 18/20%. The recent move to 125 saw trading volatility increase to 11%. We suspect USD/JPY would need to trade at or above 130 for volatility to be near 18/20% again.
USD/JPY not too stretched on valuation metrics
As noted above, the real yen exchange rate is very low by historical standards. But is it heavily undervalued? Our Behavioral Equilibrium Exchange (BEER) model shows a medium-term real overvaluation of 9-10% in USD/JPY. On average, oscillations inside the 1.5 standard deviation band (currently, +/-15%), suggest that the valuation is not too stretched. Valuation errors outside this range have normally been followed by convergence to fair value.
The terms of trade differential and the productivity differential are the variables with the highest beta in our model. It should be noted that the calculated fair value is based on 4Q21 figures, as some of the model data is only released quarterly. The sharp rise in energy prices in 1Q22 led to a further deterioration in Japan’s terms of trade, which likely pushed USD/JPY fair value higher and narrowed the misvaluation gap. In short, we don’t think USD/JPY is still at extreme overvalued levels that prevent it from going much further.
USD/JPY deviation from ING medium-term fair value model
Overall, we think a Fed tightening cycle, a dovish BoJ, and a deterioration in Japan’s balance of payments position following the fossil fuel spike will keep USD/JPY supply going through the most of the year – and that should be close to 130 by the end of the year. Probably the biggest risk from this perspective is that the BoJ becomes less dovish – as evidenced by its allowing 10-year JGB yields to trade above 0.25%. This is not what we anticipate.
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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.