The Japanese yen is undervalued. A Big Mac is cheaper in Japan than here in the USA.
The magazine _The Economist_ uses the Big Mac Index to appraise currencies. The Big Mac Index is an indicator of Purchasing Power Parity. A Big Mac is considered to be representative of goods and services. Although I have been steering clear of the Golden Arches ever since the movie _Supersize Me_ grossed me out, the fact remains that the price of a Big Mac is representative of the cost of many local goods and services, such as land, rent, labor, energy, beef, and grain.
According to _The Economist_ magazine, a Big Mac costs an average of $3.41 USD here in the USA or 280 yen in Japan. Given a current exchange rate of $1 USD = 104.150 yen (10,000 yen = $96.01 USD), an American tourist visiting Japan would only need to convert $2.69 in USD to yen in order to buy a Big Mac. Thus, the tourist would pay 21% less for that Big Mac in Japan than in the USA.
If the US dollar and the Japanese yen were at purchasing power parity, the exchange rate would be $1 USD = 82.111 yen (10,000 yen = $121.79 USD). So the 10,000 yen that currently sells for $96.01 would be fairly valued at $121.79. Again, we can see that the Japanese yen is selling for 21% fewer US dollars than Purchasing Power Parity.
To relate currencies to stocks, the Purchasing Power Parity of a currency is analogous to the book value of a company’s stock. Of course, just as a stock price can remain substantially above or below book value, a currency can remain substantially above or below Purchasing Power Parity. One reason that this disparity can persist is the fact that the real world has substantial currency exchange fees and transportation costs. Additionally, certain countries have persistently higher or lower land prices, rents, wages, and commodity prices.
However, the Japanese yen relative to the US dollar is likely even cheaper than Purchasing Power Parity suggests. Japan has a much higher population density than the US. Land is scarce in Japan, especially after you consider the fact that most of the interior is mountainous and unable to support agricultural, industrial, or residential use. Thus, Japan is a nation with high land prices and high rent. As an industrialized First World nation (like the USA, Canada, western Europe, and Australia) with a high standard of living, Japan has high wages. Natural resources are scarce in Japan, so the nation must import heavily. Thus, one would expect almost everything, including Big Macs, to be more expensive in Japan than in the US. Thus, Purchasing Power Parity provides a very conservative appraisal of the yen.
Why is the Japanese yen so cheap? Because the Japanese economy still hasn’t recovered from the recession and stock market collapse of 1990, most of the the world has given up on Japanese stocks and businesses, and this holds down demand for yen. The other reason is the extremely low interest rates (well below 1%). Low interest rates discourage investment in Japanese debt instruments (bank CDs, corporate bonds/paper, government debt, etc.), also reducing demand for yen. Furthermore, low interest rates encourage both domestic and foreign investors to borrow Japanese yen and invest the money elsewhere for higher yields. Borrowing yen is the same thing as short-selling yen, and this selling pressure also conspires to drive down the yen relative to other currencies. This practice of borrowing money in one currency and investing it in another currency is called the carry trade.
The unwinding of the yen carry trade is a potential triggering mechanism for a rise in the value of the yen. In order to liquidate the yen carry trade, one must buy back yen in order to pay off the loan. Most estimates suggest that at least $1 trillion USD is being gambled on the yen carry trade. If a large number of speculators are simultaneously forced to liquidate their yen carry trades (due to falling financial markets elsewhere or any rise in Japanese interest rates), there will be much more demand for yen. This would boost the value of the yen and force more speculators to liquidate their yen carry trades. This “short squeeze” in the yen would become a chain reaction, like the program trading of US stocks on October 19th, 1987 but in reverse.
Why did I choose to buy FXY (Currencyshares Japanese Yen ETF) to bet on a rising yen? I do not recommend opening a FOREX brokerage account to trade currencies. Unlike the stock brokerage industry, the FOREX brokerage industry does not have SIPC insurance. FOREX brokerage firms are notorious for going under without warning and taking customers’ money down with them. Also, FOREX brokerage firms are geared towards extreme speculators. Given that leverage ratios of over 100:1 and multiple trades an hour are popular among FOREX traders, they make the Dot-Com daytraders of 1999-2000 look conservative in comparison. Everbank offers Japanese yen CDs, but the FXY ETF (which holds 10,000 yen per share) is much more liquid and convenient because it trades like a stock and is not subject to early withdrawal penalties.
