Exchange Rate Forecast - USDJPY Fundamental Drivers, Technicals & Dervatives

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Looking Back at 2016

At the beginning of 2016, Custom Products forecast USDJPY of between ¥109.0 (2 equation model) and ¥114.4 (3 equation model) by December 31, 2016 (Compared to ¥120.2 at the beginning of 2016).  Our forecast differed from actual year-end USDJPY  ¥116.96 due to: 1) we had expected 2 quarter-point hikes from the FRB instead of only one, 2) we had expected the BOJ to cut its policy rate on deposits further from -0.1% to   -0.3% by December, 3) the Brexit shock which caused the GBP to depreciate 16.5% against the dollar lead to a ¥3.8 appreciation (3.45%) of the yen and 4) oil prices closed the year at $53/bbl  (10% higher than our forecast adding 1.35% to yen appreciation). Having said this, based on our 2 and 3 equation models; we would have expected the USDJPY to end 2016 between 106.7 and 113.4 with perfect hindsight.

Why has the Dollar Strengthened Since the US Election?

Since the US election, the yen has weakened from ¥104.5 to ¥115 (overshooting to 118.6). This is best understood in terms of

  1. Short-term rates,
  2. Growth expectations, and
  3. Inflation expectations.

Clearly the path for US rates has been ratcheted up since the US election. This has come from higher long-term growth expectations and increased inflation expectations from oil and a tighter labour market, lifting US real rates vis-à-vis Japan. US-Japan 10-yr yield spread, which was recovering from a September low of 1.55%, rose from 1.85% on November 7 to 2.35% by January 24. Interestingly, Japan 5-yr forward inflation expectations (FWISJ55) have risen from 0.11% to 0.62%, greater than the US increase from 2.22% to 2.55%, making the Japanese yen less attractive with increasing negative real interest rates. Similarly US 2-yr treasury rates have nudged up from .82% to 1.15% while Japanese rates have held flat at -0.24%. Finally, the 10-yr ‘real’ interest rate differential has widened from 0.32% to 0.62%.

Net-net, Custom Products would have expected a ¥7.4 depreciation from the pre-election rate of ¥104.5 from inflation-expectation adjusted short-term yields, a Y2.8 depreciation based on the real long-term yield differential and a depreciation to ¥118.1 based on the relative money supply growth (otherwise known as the Soros Chart). Each equation has been weighted by the R2 bringing our current fair value USDJPY estimate to ¥112.65 (Chart 1 dark blue line).

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