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Interest rates in Japan are remarkably low: 30-year JGBs currently yield 2.22% and 10-year JGBs yield 1.33%.  In contrast, 10-year Treasuries yield 3.75% and 30-year Treasuries yield 4.66%, so 10-year Treasuries have 242 bps of yield advantage and 30-year Treasuries have 333 bps of yield advantage vs. JGBs.

Why are interest rates in Japan so low?  The proximate cause is that Japan seems to be locked into post-bubble deflation.  And why is that?  Couldn’t Japanese monetary authorities simply do a helicopter drop of cash into the economy to defeat deflation?

In an April 15, 2010 Financial Times article, David Pilling writes:

Economically, and in spite of this week’s formation of a ruling-party faction that favours inflation-targeting, the country’s leaders nourish a fatalistic acceptance of deflation. True, 15 years of more or less continuously falling prices have not triggered the crisis some predicted. But falling nominal output has accelerated Japan’s relative economic decline.

…

Yet many Japanese seem more at ease with the idea of stately decline and genteel isolation. One of Japan’s most popular books in years, The Dignity of a Nation, even suggested Japan should stop teaching its children English and withdraw from the world trade system altogether. Short of such radicalism, many people ask what is wrong with being a backwater of wealth and civility in an out-of-kilter world.

…

For Japanese with jobs and access to savings, even deflation can be a boon. “We are just quietly enjoying our affluence,” says one satisfied customer.

David paints a picture of a sleepy, backwater Japan where people “with jobs and access to savings” are not particularly bothered by deflation.

USD/JPY is currently 92.06.  YCS closed at 20.77 on Friday, April 16.

Previously, I examined USD/JPY in terms of valuation, carry, and momentum.  We should also examine the U.S. trade deficit with Japan.  The attached chart shows annual trade deficits with Japan starting from 1985.  Last year’s trade deficit with Japan of $44.8 billion was the smallest since 1991 ($43.4 billion).

YCS closed at 20.07 yesterday.  I recommended it at 19.31 on March 3, 2010.

Let’s examine USD/JPY in terms of 1) valuation, 2) carry, and 3) momentum.

1) http://fx.sauder.ubc.ca/PPP.html shows the yen to be overvalued relative to the dollar by about 30%.

2) There is no significant difference between USD and JPY overnight interest rates, so USD/JPY is basically carry-neutral.  However, the Treasury and JGB yield curves indicate that the market expects the Fed to be much more aggressive than the Bank of Japan in hiking rates.

Long USD/JPY positions should have positive carry within a year or two.

3) Regarding momentum, the attached image tells the story: the dollar has been in a multi-year downtrend vs. the yen. It has been nearly three years since USD/JPY peaked at 124.09 (FRED daily closing values), so yen strengthening may have run its course.

USD/JPY

I am bullish on USD/JPY (bearish on yen). Right now, USD/JPY is at 88.72. I think we will see USD/JPY above 93 within six months. YCS (UltraShort Yen ProShares) closed at 19.31 today.

Recommendation: buy USD/JPY or YCS.

This article provides a good summary of the three main drivers of currency movements:

http://www.cityam.com/markets-and-investments/investors-go-back-fundamentals-they-lose-their-taste-carry

There have typically been three overarching strategies for trading the currency markets: carry, momentum and valuation.  While carry is based on yield, momentum is based on currencies’ trends over time and uses past movements in price to predict future moves. Valuation looks at the currency’s actual value versus the fair value based on purchasing power parity (PPP), a theory which holds that price levels should be roughly equivalent in developed countries.

[Originally posted on Feb 15, 2010 at the Heck.com Forum]

A friend e-mailed me the following:

i know it may be already late but I feel that EUR still has a long way to go down. Do you think it’s a good bet to short it against dollar at least temporary? If instability persists in Europe, volatility will go up and people will take money out of stock market and may temporary invest in US bonds.

I agree that the Euro has room to drop more.  To address this issue we need to consider a) purchasing power parity, b) interest rate differentials, c) and risk aversion.  To address the issue of whether it is a good idea to short EUR/USD, we need to consider catalysts for Euro depreciation.

In terms of purchasing power parity (PPP), the Euro is still somewhat overvalued – see http://fx.sauder.ubc.ca/PPP.html and http://www.oanda.com/currency/big-mac-index.  The latter suggests that fair value for EUR/USD should be about 1/0.93 = 1.075.  PPP usually produces terrible short-term predictions (we often find that “overvalued” currencies continue to appreciate and “undervalued” currencies continue to depreciate), but I think it is still useful as a rough guide to value.  See http://www.econbrowser.com/archives/2006/03/the_dollar_and_1.html for a PPP success story:

Comment by jim miller:

I used to make my living forecasting exchange rates. I found PPP to be very helpful. Back in 1994 I predicted the Mexican peso devaluation six months before the event. The convincing factors were watching some Mexican friends visit us in New York and go shopping-they said the savings were enough to pay for the trip. We also visited Mexico and the local prices-in dollar terms-were very expensive. It was obvious the peso was over-valued. So it was just a matter of time.

PPP is helpful in working with annual budgets, longer term financial planning,etc. It’s of no use to a foreign exchange trader. For those folks a long-term investment is a three-day weekend.

Short-term OECD currency movements tend to be driven by carry trades.  When there is appetite for risk, traders borrow or sell lower yielding currencies to buy higher yielding currencies.  In periods of risk aversion, this is reversed.  The reason that I use the qualifier “OECD” is that government bonds in these countries usually have very little credit risk, so higher interest rates tend to be a reflection of expectations for robust economic growth rather than credit problems.  With Greece, of course, the story is different.

10 and 30-year Bund yields are 3.2% and 3.94% vs. 3.69% and 4.65% for 10 and 30-year Treasuries, so USD has the advantage in terms of carry (or expected future carry).  At the moment, there is not much difference between U.S. overnight rates and German overnight rates, but the difference in term structures indicates a market expectation that the Fed will be more active in raising rates in the future than the the ECB.

Finally, is there a catalyst for Euro depreciation?  Yes, the problems with Club Med provide a catalyst.  Some people have pointed out that Greece has a very small economy (economic output about half the size of Illinois), so it seems like it doesn’t make sense that tiny Greece might put the common currency of the entire Eurozone at risk.  But maybe the Euro was overvalued to begin with, and this is just the kick that starts the ball rolling.

Unfortunately, this only scratches the surface.  We should also discuss the fiscal problems of the U.S., the U.S. trade deficit with the Eurozone (if the Euro is overvalued, why are we running a trade deficit with the Euro area?), etc.

Furthermore, it is tricky to manage the risk of short positions – this should be done with stop losses or put options, and both have problems.  I think the Euro will continue to depreciate, but I am unsure about the timing – and to make money on the short side, you need to get both right.  Should you short EUR/USD?  Even though I think the Euro will continue to depreciate, I can’t give you a straight answer to this because of the timing issue.  However, if instead you were already long the Euro, I would recommend selling some.

Update: Right now (March 1, 2010), EUR/USD is at 1.3557.