Weekly Digest: Playing the long game – reflections on the yen from the terraces

A new season, a new start

For those following clubs in the English Football League, last weekend saw the opening games of the new season. As a long-suffering Sheffield Wednesday fan, it was encouraging to see the team start on a positive note, with a win at Leyton Orient.

The game was the first of a new era after the club entered administration and suffered relegation last season. Wednesday set several unwanted English football records, including the earliest relegation (22 February), the longest run without a league win (39 games), and the fewest points (zero). With new ownership and a new squad, it’s very much the case that ‘things can only get better’.

The yen's difficult year

In markets, the Japanese yen has also had a tricky past 12 months. Among the G10 group of the most heavily traded developed market currencies, it’s by far the worst-performing – down more than 8% against both the US dollar and sterling at the time of writing. At the end of July, the weakness was sufficient to prompt the Japanese Ministry of Finance (MoF) to intervene in the market to support the yen for what’s thought to be the third time this year.

I can already see eyes rolling at the seemingly tenuous analogy. But stick with me on this. After the result over the weekend, while pondering topics for my guest slot writing the Weekly Digest, I realised that there are useful parallels.

Ups, downs, and tentative turnarounds

As any Sheffield Wednesday fan will attest, the past few decades have delivered more than our fair share of ups and downs. Late last season, things were bleak. Then, with a bit of assistance from a new American owner, there were tentative signs of a turnaround with a win on the final day. The situation still isn’t great – we were still relegated, after all. A near-term turnaround is far from guaranteed, either. Football never fails to surprise, and there will undoubtedly be obstacles ahead. However, if the new management continues to make the right decisions, I think most fans believe we’ll one day make it back to the promised land of the Premier League. Some fundamentals, such as a large support base and a strong historical reputation, are in our favour.

Back to currencies – the yen has also hit lows lately. From around 147 against the US dollar a year ago, it reached its weakest in four decades on 23 July, at close to 164. Intervention then pushed the yen back up to almost 157 on 3 August, before it slid back to around 159, where it has remained for the past week or so. (Chart 1 gives more context, including against sterling.)

The US has also helped drive the near-term turnaround in the yen. The US Treasury sold euros to buy yen alongside Japan’s MoF in July. This type of joint action is unusual – the last time the US intervened to support the yen was back in 1998.

Land of the falling yen

A chequered history of intervention

Like football takeovers, currency market intervention has a chequered history of success. On the one hand, some coordinated attempts, such as the Plaza Accord in 1985 – when five nations agreed to depreciate the value of the US dollar – have achieved their stated aims. But there are plenty of other examples of failure, including the repeated attempts by the MoF to support the yen in recent years.

It’s too early to know whether the latest intervention will prove successful. The coordinated nature may boost credibility, making speculators think twice before betting against the yen again. That said, as with individual football results, short-run moves can be unpredictable. This is largely down to the sheer number of factors affecting an exchange rate and the varying importance of these factors through time. Indeed, there is a strand of academic literature that can be traced back to a 1983 paper by American economists Richard Meese and Kenneth S. Rogoff, finding that exchange rate models struggle to reliably beat the simple prediction of ‘no change’ over short time horizons.

Taking the long view

In contrast, we believe there is value in taking a view on exchange rates over longer time horizons. Academic research suggests that ‘equilibrium exchange rates’ can be helpful for making predictions. By this, we mean a ‘fair value’ defined by economic fundamentals, to which it’s assumed the actual exchange rate converges over multi-year periods of time. In short, while we tend not to take a strong view on the exact route taken, we do take a view on the eventual destination.

There are numerous approaches to estimating equilibrium exchange rates. We maintain our own Behavioural Equilibrium Exchange Rate (Beer) model and monitor others'. At the simplest end of the spectrum are those based on the assumption that exchange rates, adjusted for relative inflation in different economies, should revert to a long-run average. At the other end are complex statistical models maintained by central banks and sell-side research teams.

The yen looks undervalued

Perhaps the clearest message almost all these models are sending right now is that the yen is undervalued. That’s true on our own Beer model. It’s also true for most of the complex third-party models we see. And it’s true using simple mean-reversion approaches. Macroeconomic fundamentals can’t explain how weak the yen has become.

These models essentially confirm what any recent visitor to Tokyo or Osaka will have noticed. Japan is now a cheap destination for its level of development. Deutsche Bank’s latest ‘Mapping the World’s Prices’ report illustrates this, finding that the cost of a date in Tokyo (clothes, public transport, dinner, a couple of drinks, cinema tickets, and a taxi home) is now almost half that in London. It’s also less than one in Istanbul, Bangkok, Mexico City, or São Paulo.

Reasons for cautious optimism

To be sure, a return to ‘fair value’ for the yen isn’t guaranteed. Some are concerned that the Bank of Japan isn’t raising interest rates fast enough, perhaps in part due to government pressure. Others are worried that Prime Minister Sanae Takaichi is pursuing a fiscal policy that’s a bit too loose (i.e. borrowing too much). As with Wednesday’s new management at Hillsborough, Japan’s government needs to pursue sensible policies to keep investors onside.

Reassuringly, though, the Bank of Japan has struck a more hawkish tone of late and reports last week suggested the government is supportive of a rate hike. We also aren’t overly concerned about Japan’s fiscal position, despite the high level of government debt.

All told, given the clear undervaluation of the yen, we’re comfortable continuing to hold Japanese equities, including without hedging the currency exposure. Investors should be prepared for some volatility along the way, just as I’m preparing for poor performances and the odd bad season in supporting Sheffield Wednesday. But we think that, over the long run, the yen is more likely to strengthen than to weaken. Let’s hope the same is true for Wednesday.