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  Market Insights: The Diversification Benefit of Yen Exposure

The relative strength of the U.S. economy has led to expectations of tighter monetary policy, particularly as foreign central banks move to stimulate their economies in the face of slower global economic growth. This has fueled a dramatic rally in the U.S. dollar over the past year, particularly against the euro and the yen. As a result, investors have flocked to hedged products to protect their foreign investments from continued moves higher in the U.S. dollar. We acknowledge that currency returns are difficult to forecast, particularly in the face of unpredictable central bank intervention. Although we do express currency specific views, we always evaluate these views in the context of portfolio construction, as currency exposure can often represent a source of portfolio diversification for investors. The Japanese yen, for example, has depreciated substantially over the past three years, as the Bank of Japan has pushed forward with very aggressive stimulus, while the U.S. Federal Reserve has been messaging the gradual unwinding of monetary easing in the U.S. (as shown in Exhibit 1 below).

Exhibit 1: USDJPY Historic Cross Rate

Source: Bloomberg data; Shaded area represents one standard deviation boundary (10.77%) relative to the historical 25 yr average (109.54).

During the month of August, we witnessed extreme levels of global market volatility, which coincided with a significant unwinding (albeit short-lived) of the long USD trade. This was primarily due to investors repricing the probability and pace of a rise in interest rates by the U.S. Fed, on the heels of declining expectations of global economic growth. U.S. investors who did not hedge their currency exposure benefited from the diversification of such exposures, most notably the Japanese yen. This is not surprising given the low long-term (and often negative) correlation between the Japanese yen and the U.S. equity markets. Exhibit 2 shows the rolling annual correlation of the performance between the yen-dollar (JPY-USD) cross rate relative to the S&P 500 Index.

Exhibit 2: Correlation of JPY-USD Performance to the S&P 500 Index

Source: Bloomberg data

Over the most recent market cycle, this currency relationship has typically exhibited a negative correlation to the performance of U.S. equities, which lends to the diversification benefit of maintaining exposure to the Japanese yen. As the forecasts for global economic growth and inflation become more uncertain, the actions of central banks are less predictable, and the volatility in currency markets may continue to rise as a result. Exhibit 3 below, shows the rolling one year implied and realized volatility USDJPY cross rate, which demonstrates that the volatility of this currency cross rate is on the rise and has room to move higher, based on historical observations. When outcomes are uncertain and volatility is on the rise, understanding the diversification benefit of yen exposure may be a prudent.

Exhibit 3: Realized and Implied Volatility of USDJPY Cross Rate

Source: Bloomberg data


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This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Past performance does not guarantee future returns. This material may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented.

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