- Capital flows can exacerbate currency misalignments, with USD and JPY being significantly impacted.
- We model the impact of various capital flow factors on our DEER misalignments.
- The JPY’s undervaluation was driven by higher foreign interest rates, on top of net FDI outflows.
- The USD’s over-valuation cannot be fully explained by interest rates and current account/FDI.
- In combination, USD/JPY is too elevated and could be vulnerable to a reversal due to tail risks.
Related Insights
Focusing on record USD and JPY misalignments
While a narrowing of currency misalignments is expected in the long run, capital flows may exacerbate misalignments over the short run. Our DEER strategy, predicated on a convergence towards long-term fair value, has seen returns dragged down by a short USD/JPY position amid heavy capital flows. This had completely outweighed a positive net return from other positions held by the Strategy.
Extended declines in the JPY and rally in the USD are contrary to long-term expectations, with the JPY being highly undervalued and the USD overvalued. Extreme JPY undervaluation had also raised concerns by the Japanese government, which conducted rare USD/JPY selling interventions in Sep/Oct 2022 and again in Apr/May this year. These interventions have kept speculative excesses in check and raised questions about why capital outflows have been so sustained.
Given that capital flows have become a major driver of USD/JPY ascendancy that is not aligned with our DEER valuations, we embark on a modelling of factors driving these capital flows for both the JPY and USD over two decades, to offer a clearer prognosis for the DEER strategy’s outlook.
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