Applying Occam’s Razor to the forward value of the yen
After my previous post, Brian McCarthy left the following remarks:
I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”
So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.
This is a good argument, but in the end I favor the alternative view.
Over the past 40 years, the US price level has risen from 1 to 3.975, while the Japanese price level has risen from 1 to 1.556. That means the US price level has risen by 2.555 relative to the Japanese price level. Over the same period, the yen has appreciated from 241.37 to 106 to the dollar, a ratio of 2.227. So the appreciation of the yen in the very long run is pretty close to the change predicted by PPP (although over shorter periods there are quite wide discrepancies.)
So here’s how I look at things. The simplest explanation for the forward yen trading at 50 is that the public expects Japan to continuing having lower inflation than the US, just as has been the case for the past 40 years. They expect the yen to continue appreciating, just as it has over the past 40 years.
The alternative explanation is possible, but involves more “epicycles”:
1. Yes, the Japanese yen has been appreciating in the very long run.
2. Yes, the Japanese inflation rate is consistently lower than in the US.
3. Yes, the 30-year forward yen is trading at a strong premium, just as you’d expect if these trends were going to continue.
4. But these facts are actually unrelated. Starting right now, the Japanese inflation will suddenly rise to US levels, even though the markets don’t seem to expect that. And starting right now the yen will stop appreciating. And instead some other “real factor” explains why the forward yen is trading at a strong premium, some real factor that would cause 30-year Japanese real interest rates to be hundreds of basis points lower than American real interest rates.
That’s all theoretically possible, but isn’t the simplest explanation that the forward yen is at a strong premium because investors expect the spot yen to appreciate, and they expect the spot yen to appreciate for the same reason that it’s strongly appreciated over the past 40 years?
PS. After I wrote this post (a few days ago), I discovered a similar post written earlier by Julius Probst, who has a very nice monetary economics blog. He anticipates my basic point. But read his post anyway, as it ends with some interesting remarks on Japanese monetary policy.