Morgan Stanley: Time to go Long dollar and short YEN

By Contrarian

Published: December 4, 2009

MS shots of its regular client emails and this time it has been different from past. MS, to remind, had year end target of 85 on YEN. The target has been hit and now MS has issued a new note stating to go Short YEN.

We think that Japanese authorities will want to resist yen strength around the ¥85 area, given that a break of this level sets up a test of all-time lows in USD/JPY around ¥80. Japan has not intervened in the currency market since 16 March 2004, not resisting the recent bout of dollar weakness. And despite risks to the domestic economy from the strong currency, they have kept to the spirit of the G20’s desire to deal with global imbalances. This has also been at a time when China’s renminbi has been linked to a very weak dollar. Japan has been a good global citizen, but after this week’s surprise announcement of further liquidity measures by the Bank of Japan, it is perhaps an early indication that they are getting increasingly concerned about their economic prospects at a time when other central banks are thinking more about their exit strategies. This might also imply that if the yen were to strengthen further the probability of intervention would rise quite sharply.
Coordinated intervention cannot be ruled out either, given that Federal Reserve Chairman Bernanke has
recently talked about a strong dollar being a source of global stability and that the Fed is attentive to the
implications of changes in the value of the dollar and will formulate policy to guard against risks to their dual
mandate. The recent Fed minutes also referred to the link between the dollar and inflation. There are many
countries which are currently unhappy with dollar weakness (strength in their own currencies) or the low
level of the federal funds rate such as the Eurozone, Canada, New Zealand, Switzerland, Brazil, Hong Kong,
China and other Asian countries. A general stabilization of the dollar would suit everyone’s needs and help to
contain any inflationary pressure in the US.

One of the factors behind our bullish view on the yen has been that the level of real interest rates in Japan has been the highest in G10. A simple Taylor rule, for instance, implies that the equilibrium short rate for Japan is around -3.0%. However, we believe this is already reflected in the price of the yen, and as Exhibit 2 shows, we are fairly close to seeing a turn in the real shortterm interest rate differential between Japan and the US. Going forward, this is going to be supported by relative growth differentials. In 2010, we expect the US economy to expand by 2.9%, while Japan will likely expand by around 0.6%. We also expect the yield on US 10-year bonds to be increasingly attractive for Japanese investors; we forecast this to rise to 5.5% by the end of next year while JGB yields are expected to be 1.2% by the end of next year. Obviously picking up the growing yield differential at close to all-time lows seen in USD/JPY is a fairly attractive prospect. As we expect payroll growth to turn positive by February, US yields seem likely to rise further in the short term.
The yen is now getting increasingly expensive. According to our fair value models the JPY is around 15% expensive versus the USD. Indeed, USD/JPY is now fairly close to being one standard deviation away from fair value, and it has only been through those levels twice in floating-exchangerate history. That was met with heavy intervention, especially in the 1995 episode.

Given the dollar’s role as a funding currency, if this changes it could have major implications for cross-market correlations between the dollar and other assets. As we noted in “Credibility Concerns” (FX Pulse, 5th
November), the correlation between risk assets and the dollar has risen to all-time highs; if the yen becomes the funding currency, then this is likely to change. We expect USD/JPY to rise to 101 over the next 12-months and would recommend buying USD/JPY with a stop at 84.50.

Tagged with: Dollar, EU, FED, US

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