🔎Yenageddon?
The currency is already dramatically undervalued against the Dollar. But it keeps falling even with surging interest rates. Where will this end?
In May 2024, I wrote the article below about the Yen.
I argued that the acceleration of the Yen’s decline against the Dollar was somewhat surprising at that time because the Japanese economy actually did quite well, at least relatively speaking compared to its stagnant history. The trade balance was improving and (in contrast to many other developed nations) the worst demographic momentum lay behind them. I concluded that the Dollar-Yen carry trade was the only plausible FX driver. It was the flip side of what I later dubbed the Fed SuperCycle.
The Fed’s rate hikes drove capital into the US and boosted the economy through the interest income channel and the risk rebalancing channel. Investors used Japan as the financing vehicle to fund their investments in the US. Their financial acrobatics flooded FX markets with Yen and made Dollars scarce. And in doing so, they made the Dollar-Yen Carry Trade extremely profitable. Not only did they earn the interest rate spread between both economies. They also enjoyed the Dollar’s appreciation against the Yen.
19 months have passed since that article and Japanese interest rates are going through a massive multi-decade breakout right now. It’s time for an update.
TLDR Summary
The Dollar-Yen Carry Trade is still profitable. Over the last twelve months, its total return stands at 8%. About half of that is due to Dollar appreciation, the other half is due to the rate spread between the US and Japan.
This performance is driving a huge valuation dislocation between Dollar and Yen. Purely judged by inflation data, the Dollar is now overvalued by about 70%. Ultimately, this will have to mean revert. I wouldn’t hold my breath for that in the near to midterm though. Too many investors seem to be betting precisely on that mean reversion right now.
The Yen/Dollar exchange rate has become a proxy for Fed rate cut expectations. The Fed paused its rate cuts for much of this year, primarily as a concession to the strong AI capex boom in the US which drives economic growth and keeps interest rates high. The affection many investors seem to have for the Yen is a surprising bullish data point for the Dollar and by extension the US stock market.
Carry trade performance
In my Carry Trade Index, I assumed a hypothetical carry trader who borrows in the Japanese money market and invests that into the US money market, i.e. he gets the Dollar’s appreciation against the Yen plus Dollar interest income minus Yen interest expense.