With a majority of developed markets rallying strongly over the last several years, we think the single biggest determinant for investors actually being able to capture those returns has hinged on their ability to manage currency risk. Owning foreign assets in any currency other than the U.S. dollar has generally resulted in a painful combination: being on the right side of the trade, but seeing profits eroded from weakening foreign currencies. As we noted last summer, relative short-term interest rates can significantly impact the value of one currency versus another. However, relative rates may not always give the full story. Case in point: What’s driving the value of the euro and the yen now that short-term interest rates in both Europe and Japan are hovering around 0%? As we show in the remainder of this piece, the relationship between the euro and the yen is being driven by the markets’ perception about the effectiveness of central bank policy.

So far in 2015, an overwhelming majority of analysts and traders are forecasting another year of dollar strength. While consensus views often make investors nervous, we believe that the drivers of a longer-term trend in the dollar remain firmly intact. Most notably, anticipated divergence between the U.S. Federal Reserve (Fed) and foreign central banks becoming a reality will likely help accelerate this trend.

However, as shown in the chart below, with short-term interest rates anchored around zero in Europe and Japan for the last two years, interest rate differentials did little to explain the dramatic weakening in the value of the yen compared to the euro. So what can explain this dramatic rise? To put it simply, quantitative easing (QE).

Exchange Rates vs. Short-Term Interest Rates (12/31/1999–2/20/2015)
Germany & Japan: 2- Year Rate Differential vs. EUR/JPY (RHS)

With few other policy tools available to central banks with policy rates near zero, the Bank of Japan (BOJ) has unleashed a series of aggressive asset purchase programs in order to provide a shock to the Japanese economy. In doing so, how can the BOJ manage the effectiveness of its policies other than through the prices of the Japanese stock market? While the prices of risky assets are one way, a more nuanced approach would be to measure investors’ thoughts on future inflation. Since a primary goal of QE is to reverse deflationary tendencies, an uptick in inflationary expectations provides one barometer for QE efficacy.

For the last 20 years in Japan, deflation has stifled domestic consumption and made investment unattractive. Since the end of 2012, the yen has declined by more than 15% against the euro. As shown in the table below, the markets’ perception of inflation expectations can explain a significant portion of the decline in value of the yen versus the euro.

Exchange Rates vs. 5-Year, 5-Year Forward Inflation Expectations
Euro/Yen Exchange Rate vs. 5-Year Inflation Expectations (RHS)

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