How cheap is cheap?

The extent of Japan’s monetary easing is difficult to comprehend even in hindsight. Let’s compare the yields on three-month JPY and USD LIBOR on logarithmic scales (JPY LIBOR would be difficult to depict otherwise). The historic easing and subsequent tightening engineered by the Federal Reserve is highly visible.

The USD scale goes down to 1 percent. The JPY scale has to go down another two cycles, to .01 percent. Japanese yen LIBOR fell below 5 basis points in 2003, an absolute level more than 20 times lower than the USD low-point. It is not the level of JPY or USD rates that determine how the non deliverable forwards will be priced, but rather the reinvestment rates three months from the time of the spot transaction. The best metric for these is the forward rate ratio (FRR) between six and nine months.

This is calculated by taking the forward rate between six and nine months (the rate at which you can lock in three-month borrowing starting six months from now) and dividing it by the nine-month rate
itself. The more the FRR exceeds 1.00, the looser the money policy is. A FRR less than 1.00 indicates an inversion of the money market curve.

The JPY FRR was less than its USD counterpart for long stretches of time in the first half of the 90s, and predictably the JPY soared against the USD in reflection of Japan’s tighter money policies. This changed abruptly after the JPY peaked in March 1995, and then the JPY predictably weakened. However, during the long stretch after quantitative easing began, the JPY rose until late 2004, at which point the Federal Reserve’s rate-hike campaign began to firm the USD.

Can we therefore adopt a simple trading strategy — going short the JPY as long as the JPY FRR exceeds its USD counterpart? Absolutely not: Not only is the impending end of the Bank of Japan’s quantitative easing program going to put an end to the massive borrowing and-selling of the JPY, but Japan’s customers will need to buy JPY to pay their bills. The JPY may drift lower over time but be interrupted by violent short-covering rallies. Sell and hold will not work.