Gavekal Capital: Solving the Mystery of Why the Yen has not Fallen More

Wednesday, May 7, 2014

Solving the Mystery of Why the Yen has not Fallen More

After undergoing a fairly rapid depreciation from the end of 2012 to mid-2013 the yen has traded in a more or less sideways channel and has recently been parked between 101-104 per USD. Given the monetary largess provided by the Bank of Japan, this has come as a surprise to many Japan watchers who expected the yen to fall much further. So why hasn't the yen met those expectations even as it becomes crystal clear that the BOJ is running the easiest monetary policy of any major central bank? Well, in a world of zero interest rates and low inflation it may just be that the most important factor behind currency moves boils down to nothing more than the relative quantities of money in each currency, which in turn boils down to the relative size of each central banks' balance sheets.

In the chart below we plot the JPY/USD exchange rate on top of the ratio of total assets held by the BOJ relative to total assets held by the Fed. For the remainder of 2014 and 2015 we have made a low and a high forecast for where this ratio is likely to end up given what we know about about BOJ and Fed policies. For the low forecast we've assumed that the BOJ continues at the current pace of accommodation by buying ¥70tn in assets in 2014 and 2015 (more or less the stated policy). The high forecast assumes the BOJ doubles down on QE and buys assets at an annual pace of ¥140tn starting in November of this year. Both forecasts assume the Fed will conclude the tapering process in December 2014.

What we see is that the JPY/USD exchange rate has for the most part followed the path of the relative size of the central banks' balance sheets. From 2007-2012 the Fed was clearly out-QEing the BOJ and the yen rose from 120 to 75. When the BOJ voiced its intention to join the global currency war at the end of 2012 the market immediately discounted a reversal of that trend by pushing the yen back down towards 100, even though the level of eventual monetary accommodation was not entirely clear at the time. Based on this model it even appears as though all stated BOJ asset purchases through 2015 are currently discounted, as our low forecast for this ratio would have the yen at a little under 100 per USD. This phenomenon might go a long way in explaining why the yen hasn't fallen further. If however, the BOJ decides to come out guns blazing and double up on asset purchases sometime later this year (our high forecast), then JPY/USD of 120 would seem warranted.