The Yen Reloaded: A Hidden Hedge?

Markets have had a turbulent start to the year. The DeepSeek shock hit the Magnificent Seven hard, leaving them near early December lows. Now, investors are turning their attention to reciprocal tariffs¹ and rising geopolitical tensions.

The U.S. and Ukraine are moving closer to a minerals deal, potentially tied to U.S. commitments to Ukraine’s sovereignty and security. Meanwhile, Donald Trump confirmed that delayed tariffs on Canada and Mexico will proceed as scheduled. These developments have weighed on global equities, which pulled back from mid-February highs.

This reinforces our view: selecting the right hedges will be critical this year. Gold—one of our preferred portfolio hedges² — has gained renewed attention, and we continue to see further upside. But another asset, often overlooked, deserves a fresh look: the Japanese yen.

Despite being sidelined in recent years, the yen is once again proving its value as a hedge in uncertain times. In the following analysis, we explore why investors should reconsider its role in a well-balanced portfolio.

Strong undervaluation

The yen lost its appeal as a portfolio diversifier in early 2022 when the Bank of Japan (BoJ) maintained its ultra-loose monetary policy while other major central banks tightened. This policy gap fueled a resurgence in the yen carry trade, with investors favoring short positions. As a result, the yen’s negative annualized carry widened to -6% against the U.S. dollar, before narrowing to -4% today.

Between 2021 and mid-2024, the yen weakened by approximately 36% against the dollar and 28% against the euro, pushing USD/JPY to its highest level since the late 1980s. Now, the yen stands at a historical undervaluation versus the euro (Figure 1).

For investors, the question is whether Japan’s monetary stance will shift and what that could mean for currency positioning. A reversal in policy could spark renewed interest in the yen as a hedge and a diversification tool. Understanding these dynamics is key to navigating currency risks and opportunities in global portfolios.

The two FX patterns

Simple valuation measures, such as purchasing power parity (PPP), have predictive power in developed markets. This is because currencies tend to follow two patterns³:

Pattern 1: Deviations from purchasing power parity (PPP) tend to correct over time through a mean reversion process. Figure 2 illustrates this pattern over a five-year horizon.

The horizontal axis represents the deviation of developed market real exchange rates from purchasing power parity (PPP) at a given point in time. The more a point lies on the right of the x axis, the more the currency is overvalued with respect to its PPP. The vertical axis shows the change in the real exchange rate over the next five years. While not a perfect fit, the negative trend line suggests a clear pattern: overvalued currencies (right half of the figure) tend to depreciate (lower half), while undervalued currencies often appreciate.

Pattern 2: Mean reversion in exchange rates occurs primarily through nominal exchange rates, not price levels. This means that mean reversion will manifest itself in the exchange rate directly, something that we, as investors, can act on. This key observation highlights the potential profitability of value-based currency strategies over time.

Since purchasing power parity (PPP) is calculated in real terms, distinguishing between price effects and exchange rate movements is crucial for assessing its forecasting power. Figure 3 illustrates this by plotting real exchange rate changes over five years against nominal exchange rate changes for the same period. The strong alignment of data points along a positively sloped trend line—with an exceptionally high R² value—shows that real exchange rate adjustments are primarily driven by shifts in nominal exchange rates.

These two regularities demonstrate that currency over- and under-valuations correct over time, with the adjustment mainly driven by nominal exchange rates. This reinforces the idea that deviations from purchasing power parity (PPP) can be a reliable signal for FX strategies.

Short-term support for the Yen

The yen’s historical undervaluation and its statistically significant mean reversion to fair value make a compelling case for its appreciation potential. However, it’s important to note that this relationship does not hold in the short term, as mean reversion is significant only after one to two years. Therefore, we do not use the valuation signal as a short-term trading cue, unless specific triggers accelerate the reversion to purchasing power parity.

We believe such catalysts are now in play. Beyond its undervaluation, the yen stands to benefit from narrowing interest rate differentials between Japan and major economies like the U.S. and Europe. While the Federal Reserve⁴ and the European Central Bank remain in an easing cycle, Japan appears committed to policy normalization. Growing signs of an exit from deflation support the Bank of Japan’s (BoJ) shift away from ultra-loose monetary policy—removing a key justification for short yen positions.

The yen has long been a favored short in carry trades, but this policy shift could diminish its appeal. That’s why we see potential for unwinding as interest rate and yield differentials move in the yen’s favor.

How we navigate

Since January, market focus has shifted quickly, with several geopolitical challenges testing market resilience since mid-February. Given the ongoing uncertainty in the months ahead⁶, we remain vigilant — despite our constructive medium-term outlook—and continue to focus on selective portfolio hedges, such as gold, put option strategies, and, as mentioned above, the yen.

The recent unwinding of the carry trade, which saw the yen rise by 5% in just two trading days, serves as a clear reminder of the yen’s ability to protect portfolios during periods of disappointing economic news.

We’ve held an active overweight position in the yen since last summer. We view the rising hawkishness of Bank of Japan officials in 2025 as confirmation of our outlook for rate spread tightening between Japan and the rest of the world, providing strong fundamental support for the yen this year.