Key quotes from the Deutsche Bank FX report:
USD/JPY fair value is…
Japan’s biggest problem with the current yen rally is that it is justified by fundamentals. Across most of our metrics, USD/JPY is still expensive or only just approaching fair value. US – Japan real rate differentials have narrowed significantly this year, helped by Fed dovishness and the collapse of (actual and expected) inflation in Japan. The good news is that on real rates USD/JPY is close to fair value around 110 (figure 1). The bad news is that on more medium-term frameworks USD/JPY remains significantly overvalued. Taking the average of three Deutsche Bank valuation models (PPP, BEER, FEER), we come up with a USD/JPY equilibrium value of 97, more than 10% below current levels (figure 2). There are two main implications of this analysis.
First, it is unlikely that Japanese FX intervention is going to be very successful in pushing USD/JPY significantly higher – there is no misalignment to correct in the first place. The very public commitments the G20 have made against competitive devaluations make large-scale, sustained intervention even less likely.
Second, unless the BoJ can convince the market that it is able to bring inflation expectations back up (and real yields down), it is unclear what can be done to reverse the yen rally. On the one hand, the market is likely to challenge the reflationary impact of further rate cuts into negative territory. On the other hand, an expansion of JGB purchases seems more straightforward, but it is not clear how many more marginal JGB holders are left to squeeze out into other (foreign) assets. In recognition of these limits, we revised our Q2 USD/JPY forecast down to 105 back in February.
Going forward, large-scale BoJ equity purchases and renewed fiscal stimulus may be the only near-term hope left. But if current trends persist, a new round of ground-breaking policy experimentation may be required. We are exceptionally focused on the Japanese reaction to what is happening this year, because it is likely to foreshadow the market’s perception of the next round of policy innovation by global central banks.