US Dollar / Japanese Yen Exchange Rate Forecast

I wrote in the last monthly forecast that “the decline to 8480 in November probably completed a diagonal triangle from the 2007 high at 12420.  The low was in a spike fashion and occurred at the midline of a well defined multiyear channel.  Nearing potential resistance now from a measured level at 9335, structure is bullish above 8735.  Another measured level is 9705.  Looking further out, moves that follow leading diagonals (which this probably one) often retrace a significant portion of the decline.”  The USDJPY has broken out and is approaching the initial objective near 9700.  Support should be strong in the 9200-9300 region. 




The yield-sensitive US Dollar/Japanese Yen pair has likewise felt the effects of a bounce in US interest rate expectations, rallying strongly through recent trade. Much was made of the fact that Japanese 3-Month London Interbank Offered Rates (LIBOR) had crossed above their US counterparts for the first time in a very long time. Yet March saw US 3M LIBOR cross above the equivalent Japanese rate, and current interest rate expectations suggest that they will remain above for the foreseeable future. This alone should continue to bolster the US Dollar against the Yen, and the clear gulf in interest rate expectations only supports the argument for USDJPY strength.

The only caveat remains that interest rates only matter during expansionary market conditions. If financial markets take a significant turn lower, then we could easily see the Japanese Yen strengthen against the US Dollar and other counterparts.



Prices are now just 0.4 percent off from the PPP-implied exchange rate and a move into overvalued territory is possible from here. The pair remains closely tied to the outlook for US interest rates with the percent-change correlation between USDJPY and the yield on US 10-year Treasury notes now at 0.80. In fact, data going back to 1980 suggests a very strong positive relationship between long-term bond yields and USDJPY, hinting that the pair will push higher as the US Treasury begins selling record amounts of debt to finance America’s gaping budget shortfall. Short rates have also lined up in favor of the greenback, with the 3-month US Libor rate tracking above that of the Japan’s once again having inverted for the first time since 1993 in August. Still, there is not much of a disparity here exploit from a valuation standpoint at present.


What is Purchasing Power Parity?
   
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.