USD/JPY Could Fall Back To Its Recent Lows As USD Liquidity Remains High

The USD/JPY currency pair, which expresses the value of the U.S. dollar in terms of the Japanese yen, has traded in a generally non-volatile fashion since April 2020 (after the pair saw an extremely volatile Q1 2020). The daily candlestick chart below illustrates USD/JPY price action through 2020 (the vertical dotted line being the first trading day of the year).

USD/JPY Price Action in 2020

(Chart created by the author using Trading View. The same applies to all other candlestick charts presented hereafter.)

Looking past the volatility, especially in Q1, we can see that the U.S. dollar is evidently grinding lower against the Japanese yen. One key factor is the fact that the U.S. Federal Reserve’s short-term rate has dropped this year to the zero lower bound, effectively offering no appeal from a carry-trade perspective versus currencies including JPY. The Bank of Japan’s short-term rate of negative -0.10% compares to the Fed’s 0.00-0.25% target rate. While technically positive, this spread is slim enough to present effectively no carry-trade appeal all considered (after FX brokerage fees, taxes, etc., not to mention the potential for more volatility).

Therefore, regardless of risk sentiment, USD/JPY should not have any particular speculative bias. Also, while funding costs may have spiked in Q1 2020 as demand for USD spiked, FX swap lines offered by the Fed (to other major central banks) have sent funding costs crashing lower (in line with the Fed’s monetary policy rate). For example, in April 2020, three-month USD LIBOR (one popular measure of USD funding rates) was still over +140 basis points (the Fed cut its short-term rate to zero in mid-March). More recently, three-month USD LIBOR is just +25 basis points.

Three-month USD LIBOR Rates

(Source: global-rates.com)

As shown in the table above, three-month USD LIBOR also seems to have fallen through the month. Clearly, the U.S. dollar is liquid, and the Fed’s interventions have clearly succeeded. Yet, this has been at the expense of USD strength, as even the euro (in spite of the ECB’s negative deposit facility rate of -0.50%) has surged higher. The euro is the next most widely held reserve currency (representing about 20% of central bank reserves, as compared to the USD’s 60% share).

Japan’s three-month LIBOR is approximately negative -5 basis points, which is indeed cheaper than USD, but this is to be expected given Japan’s negative rates. Since USD funding has fallen, we can expect increased international demand for U.S. treasuries, perhaps further out the curve considering that short-term maturities (such as one-year treasuries) are already around all-time lows (currently about +13 basis points at the time of writing; the midpoint of the Fed’s target rate range).

While international flows into USD (whether treasuries, stocks or both) may provide USD with short-term strength, longer term the reduced USD funding costs are more likely to support further USD softness. As risk sentiment has truly reasserted itself this year, with U.S. equities now at all-time highs, it would appear that safe haven flows into USD are likely to remain limited for the time being (especially as markets are now likely confident in the Fed’s likely heavy intervention to any further runs on USD).

The Fed’s U.S. dollar liquidity swaps are now down to $92.14 billion outstanding as at August 20, 2020, while the bulk of this is outstanding to Japan (at $74.79 billion). This would suggest that USD liquidity may still be a little tight from Japan’s perspective, which is possibly one reason why USD/JPY has not quite crashed as we might expect given the strength that we have seen in EUR/USD. The U.S. dollar may be weak versus EUR, but USD swaps outstanding to the ECB are only about 10% of the Bank of Japan’s outstanding amount.

In the short term, we may therefore continue to see USD/JPY grinding lower (in line with the current trend) but at a steady clip. The Bank of Japan’s arrangement with the Fed may be the largest among its other central bank peers, but it is still moving in the right direction (lower), which is probably a negative sign for USD/JPY.

In the spirit of recent articles of mine, we can also look to OECD data to examine the relative purchasing power parity value of USD versus JPY. I have constructed the chart below using the OECD’s own PPP model data.

USD/JPY Purchasing Power Parity Value

(Data sourced from the OECD and Investing.com)

The red line indicates the PPP value, which dropped steadily from 2000 through to 2012, after which point it has stabilized around 65-75 yen to the U.S. dollar. Yet, in part because of USD’s world reserve currency status (and perhaps higher interest rates), USD has enjoyed a large premium versus JPY on a trade basis. The chart below illustrates this through to the end of 2019.

USD Premium to JPY (PPP Basis)

This is a significant implied premium; almost 60% (down from its peak of almost 80% in 2015). With a likely similar premium at the moment in 2020 (based on current USD/JPY prices and a presumably relatively steady PPP value), USD/JPY has a lot of room for further weakness. EUR/USD has been rising in the spirit of a weaker USD premium following the Fed’s significant interventions this year. While the United States is unlikely to want to give up its world reserve currency status, a weaker USD is supportive of U.S. exports, which is positive for the economy.

On this matter, we can also compare the ratio of export prices to import prices of both the U.S. and Japan (i.e., the terms of trade of these two countries). The chart below reveals that the U.S.’s terms of trade have fared worse than Japan’s this year.

USD/JPY Terms of Trade Comparison

(Source: Trading Economics)

Given low USD funding rates, a stronger EUR/USD, a winding down of Japan’s FX swap line with the U.S. Federal Reserve, and a significant drop in U.S. terms of trade, I do not believe USD deserves such a high premium to JPY on a PPP basis. You can also compare the OECD PPP model to The Economist‘s famous Big Mac Index, which indicates that JPY is undervalued versus the U.S. dollar to the tune of 36%, or 22% on a GDP-adjusted basis (July 2020).

As I noted in my recent article covering EUR/GBP, we shouldn’t necessarily expect different PPP models to match up perfectly, but we should expect them to roughly match directionally. In this case, the Big Mac Index (a crude but useful model) seems to confirm the OECD data. I think that through the rest of 2020, USD/JPY has plenty more room to fall further. The recent low (of this year) was registered at the 101 handle. USD/JPY 101 would, therefore, serve as a possible first target, and I believe this is an attractive “short” opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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