ENM: Yen is overvalued based on interest rate differentials
The Dollar Yen exchange rate is 0.364% higher on the day with 1 USD = 82.6800 JPY.
Research out today from Bank of America Merrill Lynch has suggested that the Japanese Yen could be overvalued at current levels as it has decoupled with its historically important relationship with interest rate differentials.
Historically, USD JPY has tended to closely follow US-Japan interest-rate differentials, particularly in the two-year sector. This is partly because higher rates in the US make carry trades more attractive. However, despite a selloff in the US rates market since November 2010, the JPY has not depreciated as much as can be implied by the size of the selloff in US rates (See chart).
"We expect this dislocation to correct in the medium term. In our opinion, the deviation of USD JPY from the rates differential has been caused by seasonal flows helping to underpin the Japanese Yen. Japanese financial institutions, particularly JPY-funded life/non-life insurers, tend to refrain from new foreign asset investment in 1Q, particularly in February, ahead of end-of-March book closings. In fact, Japanese residents’ net purchases of foreign securities have recently slowed, with net sales of foreign notes/bonds during 23-29 January for the first time in six weeks.
"On the top of this, non-Japanese investors, including foreign exchange reserve managers, have continued to be net purchasers of Japanese money-market instruments. As a result, it has become less easy to recycle Japan’s large current account surplus, which has recently widened, with unhedged capital outflows at prevailing Japanese Yen exchange rates.
"These flows, by their seasonal nature, are unlikely to persist beyond Q1.
Also to blame for the imbalance are US fiscal concerns. Although concerns about US sovereign credit are likely to persist, the credit outlook for the US ultimately depends on growth.
Therefore, perceived US sovereign credit is likely to deteriorate only together with US growth expectations. In this scenario, however, the front-end of the US curve should rally as the Fed is likely to stay on hold for longer than the market currently expects.
