- USD/JPY may be close to peaking with reversal expected on the horizon

- Bank of Japan is lagging behind other central banks despite signs of inflationary pressures

- USD/JPY is likely to fall back from 109.0 to 100.0 over coming months

© Rawpixel.com, Adobe Stock

The Yen may have hit rock-bottom and could present an attractively-priced buying opportunity, says Maxime Alimi, head of investment strategy at Axa Investment Managers.

Although the currency has been one of the worst performing in recent months due to the return of the carry trade as an influence, it may, also, have the greater untapped potential to recover.

"We believe the Japanese yen looks attractive on the back of macro, valuation and sentiment indicators. As a result, we see its current level as good entry point," says Alimi.

Carry-trading involves borrowing a currency where interest rates are low, such as the Euro, Yen or Franc, and using it to buy a currency and park the money where interest rates are high, such as the US Dollar, the New Zealand or the Australian Dollar. The difference between what it costs the trader to borrow and the higher interest earned where it is parked is the profit.

Essentially cross-currency arbitrage - carry trading has led to increased buying of higher yielding currencies and increased selling of lower yielding funding currencies, and is partly responsible for the recent depreciation in the Yen.

Yet low-interest rates are not expected to last in Japan - inflation is on the up after years of moribund price-growth, a point reflected in the higher Citi inflation surprise Z-score index score for the currency in the table below, where it is currently in the top spot.

The labour market is extremely tight in Japan, with unemployment at a very low level compared to western counterparts. There now also appears to be wage rise osmosis crossing over from part-time to full-time work, and this is expected to start pushing up broader inflation in time. Being tasked with managing inflation, the BOJ will have to react to the rising inflation by ending QE and raising interest rates.

Japan is the G10 nation where monetary policy is "lagging the most" behind leaders such as the US and Canada, yet given the above factors the exceptionally low interest rate environment may soon start to look out-of-place, which could lead to an adjustment higher. Such an adjustment would be expected to produce a comparable rise in the Yen.

Another supportive factor for the Yen is that it is undervalued according to the valuation method known as Purchasing Power Parity. PPP estimates the exchange rate is currently almost 10% undervalued. The expectation is that it will drift back up towards fair value over time.

The PPP fair value estimate for USD/JPY is 100 Yen to the Dollar, well below the 109 of the current spot price, therefore, a move lower is indicated.

PPP works on the principle that the exchange rate should be at the level where two comparable goods cost the same in both countries. One common good used for PPP estimation is a MacDonald's Big Mac since it is universally available. If a Big-Mac costs $3.00 in the US and 300 Yen in Japan, then the exchange rate according to PPP should be 100 Yen to the Dollar - if it isn't then it is expected to drift down towards fair value over time - although with PPP there can be a long lag.

The final argument for a stronger Yen is based on positioning which has shown a flip from negative to moderately positive.

Positioning basically refers to the balance of bets that large funds and speculators have on a currency. It is measured using data from derivatives exchanges such as the Chicago Mercantile Exchange. Essentially it is read as an indicator of extremes in sentiment.

When an extreme is reached, reflected in overweight long or short positions in a currency, the inference is that the currency is about to reverse from the direction of the extreme - thus extreme bullish bets are an indication of impending weakness and extreme bearish bets an indication of impending strength.

For the Yen the position is moderately bullish - and therefore not bearish for the Yen since only an extremely bullish position would be flashing warning lights.

Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.