Will USD/JPY Finally Break?

USD/JPY has been frustratingly stable but our bias is to expect it to break lower:


  • The BoJ kept policy on hold last week and gave no indication that it is about to increase its asset purchases.
  • Valuations are stretched. Our PPP model says that USD/JPY is overvalued by more than 20%
  • Positioning and sentiment indicators show excessive pessimism towards the yen. Long Nikkei/short yen trades have made no money for investors over the past year. Investors may be losing patience with this trade and may cut their positions at the first signs of trouble. This could cause a cascading effect as stop-losses get triggered, leading to further selling.

Bottom Line: Fundamentals and technicals point to a downside break in USD/JPY. Also, as last week’s events in Ukraine/Russia highlight, global risk aversion can spike without warning. Shorting USD/JPY serves as a valuable hedge to portfolios.

Low Potential?

One of the raging debates among economists and investors these days concerns the size of output gaps in the major developed economies. If output gaps are smaller than widely believed, central banks will need to tighten monetary policy earlier than expected, which could trigger a selloff in equity and bond markets.

The IMF estimates that the output gap will reach 2.2% of potential GDP in advanced economies in 2014, down from a high of 4.9% in 2009.

What is often overlooked is that output gaps would be much larger today had it not been for a significant decline in potential GDP growth. Chart 1 shows the growth of real potential GDP in a variety of countries and regions since 2008. Each panel contains two series: one drawn from the IMF’s April 2008 World Economic Outlook database; the other from the most recent projections released in April 2014. (The IMF did not make output gap projections back in 2008, so I assumed that whatever output gap the IMF estimated for 2008 would eventually converge to zero in 2014; this allowed me to back out projected potential GDP growth).

Low Potential? - Chart 1

The numbers are striking. For advanced economies as a whole, the IMF estimates that real potential GDP will be 7% lower in 2014 than what it projected in 2008. For some countries, the drop in potential GDP growth is immense: for example, the IMF estimates that real potential GDP in Spain will be 21% lower in 2014 than what it had projected in 2008. In the case of the U.K., potential GDP is likely to be 10% lower.

Are these estimates correct? To be sure, potential growth must have slowed over the past six years relative to what the IMF had expected before the crisis. The Great Recession led to a steep drop in capital spending, which sapped productivity. It also undoubtedly caused many people to flee the labor market, some of whom are unlikely to return.

Yet, the sheer magnitude of the downward revisions to potential GDP strikes me as excessive. The weakness in capital spending has likely pushed up the rate of return on capital (this is one reason why profit margins are so high), which should give a nice cyclical boost to capital spending going forward. In addition, a large share of youth who dropped out of the labor market will eventually return (quite a few decided to stay in college, which is not necessarily a bad thing). And perhaps most importantly, many workers who remained in the labor force have ended up in substandard jobs that do not fully utilize their skillsets. Stronger labor demand over the next few years should allow them to transition to jobs where they are more productive, helping to boost potential GDP.

Back in the 1930s, many commentators argued that the economy had suffered a permanent loss of capacity. Yet, as Chart 2 shows, real per capita GDP eventually returned to its pre-Great Depression trend by the 1950s. If this happens again, it would imply that today’s estimates of potential GDP are too low, which is another way of saying that the output gap may be bigger than widely estimated. In that case, tightening too early because of a fear of diminished spare capacity would be a huge mistake (just as it was in 1937).

Low Potential? - Chart 2

I suspect that Janet Yellen is quite sympathetic to this line of thinking, and as such, she will want to see a meaningful burst of inflation before she starts to hike rates. But if the output gap is bigger than commonly believed, as I think is the case, that burst of inflation may not occur for several more years at least. This calls into question the widely-shared view that the Fed will start raising rates next year.