Macro Report 16: A Classic Vicious Circle— The Japanese yenMay 3, 2022

The Japanese yen (JPY) appears to be locked into a classic vicious circle, aka. self-feeding trend or boom-bust cycle to the downside.  In this issue, we will briefly examine the theory and process of a vicious circle; and present fundamental evidence a new rationale may be forming, which would likely lead to a significant correction or major change the trend. We will also look at the elliott wave pattern on USDJPY.


“Nowhere is more nonsense talked than by currency experts about foreign exchange.”


–Winston Churchill


We look at two aspects of theory of a vicious circle for a currency:

1)     Trilemma (Mundell-Fleming)

2)     Reflexivity (Soros)

Mundell-Fleming Trilemma

The Mundell-Fleming Trilemma says policy makers can control only two of the three main variables in global finance, but not all three at the same time.

“…it is not feasible to have at the same time a fixed exchange rate, full capital mobility and monetary policy independence. Only two of the three may co-exist (according to the Mundel-Fleming logic),” writes Helene Ray, of the London School of Business, International Channels of Transmission of Monetary Policy and the Mundellian Trilemma

With almost all major central banks, and most importantly the de facto global central bank—the US Federal Reserve—becoming increasingly hawkish (with the market now expecting up to 350 basis points in hikes this year), Japan have chosen to take their monetary policy in the opposite direction.  Thus, significantly widening the yield spread in favor of the US dollar as you can see in the chart below comparing the Japanese and US 2-year benchmark yield (red line) to the pair—JPY-USD (black line):

Japanese and US 2-year benchmark yield

There is a tight positive correlation between the spread and the value of the yen.  I.E., a fall in the spread (favoring deposits in the US over Japan) leads to a decline in the value of the yen.  (Hot money seeking the highest total return, as discussed below.)

So, from a Trilemma perspective, Japan’s insistence on sovereign monetary policy (out of line with other G-7 players) and free capital flow has been very bad for the yen. 


Reflexivity as a theory for financial markets was first proposed by George Soros, in his book Alchemy of Finance, published 1987.  (We share the short-version here.)

In essence, reflexivity is a common-sense idea.  Effectively it says price equilibrium doesn’t not exist in the real world, because all market prices are flawed as they in turn are dependent upon participants expectations.

 Reflexivity includes a pair of recursive functions (constituting a procedure that can repeat itself indefinitely):

1)     The cognitive function – thinking

2)     Participating function – acting

“On the one hand, participants seek to understand the situation in which they participate; on the other, their understanding serves as the basis of which influence the course of events.  The two roles interfere with each other.”

Thus, decisions to “buy and sell are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions.”

The upshot: Players can’t be sure what is really moving currency prices—trade, interest rates, inflation, deficits, geopolitics, economic growth, on into infinitum.  In the mind of those riding the trend in the right direction, all can represent valid rationales for the move.  Thus, it emboldens those who are “right” to add to positions.  This process becomes a feedback loop—or the raw material for a self-reinforcing trend. 

Feedback loops, whereby the fundamentals can impact price and price in turn impacts fundamentals. This process is more powerful in currency markets than in the stock market precisely because it is more difficult to pinpoint the fundamental drivers for currencies (a host of potential macro factors), whereby there are real valuation gauges for stocks (earnings, cash flow, etc.). 

And as it relates to currencies, the movement of the currency itself can become the most profitable component of the total return equation.

↑Expected Total Return = ↑Interest Yield + ↓Inflation + ↑Future Exchange Rate                                   

This equation says the primary rationale for holding a particular currency is to maximize total return.  That makes sense.  Thus, expected total return will drive capital flow. 

Capital flow is made up of two components: long-term portfolio flows or long-term capital investment in a country, and speculative capital flow—hot money sloshing back and forth across boarders seeking the highest return. Of the two flows, hot money has the greatest impact on currency prices within a speculators normal time frames. 

And as said above, often the strongest component of return is the appreciation (if long) or depreciation (if short) in the currency itself.  It can overwhelm the real yield component and why we often see currencies increasing in value relative to other currencies which offer a higher real yield.  Thus, it is why self-reinforcing trends take on a life of their own relative real world fundamental and leads to overshoot-a drastic misalignment between value and price.

But trends do not form out of thin air.  There is an underlying rationale for initiation of the trend.  This leads us to the process of how trends are created, sustained, and eventually reversed.


Here is a roadmap of a typical currency cycle*—the self-reinforcing trend—from extreme bearishness to extreme bullishness and back.

  1. Extreme bearishness—this is the stage where “shoe shine boys” are shorting the currency and can articulate the rationale to anyone and everyone who will listen.  This is when things seem the most bearish, but are in reality most bullish (as later can be seen with the elusive gift of hindsight). This is Tao of the market time!

  1. Conversion flow—this is the stage when bears (during a long downtrend) start to question their “so obvious” rationale for being short.  It is the stage where the flaw in perception of the crowd begins to be recognized by members of the crowd.  Conversion flow has an early stage and a more advanced stage.  It is why we see increased volatility when the trend changes.  The players begin to realize something has changed.  But they realize it at different times. 

  1. Perception of the trend—this is the stage where the crowd recognizes that a new trend may be underway.  They have discarded the old rationale and are beginning to accept the new one. 


  1. Capitulation to the trend—now the trend is fully underway.  The crotchety old diehard bears can’t hold out hope any longer—they capitulate and buy into the new trend.  Often this is a sign that the new trend is actually becoming a bit stale, for now even the diehards are along for the ride.

  1.  Extreme bullishness—now the “shoe shine boys” are buying the currency and are articulating the rationale to anyone and everyone who will listen.  This is when things seem the most bullish, but are in reality most bearish.

*Source: John Percival, The Way of the Dollar

A pictorial representation of the process is below.

Boom bust sequence

Though the rationales and drives may not be exact, a vicious circle in the yen can be seen as a virtuous circle for the US dollar.  (You can see that many of the factors which can lead to a virtuous circle for the dollar are breaking done, albeit yield and safe haven still seem strong rationales; once these reverse, the dollar will likely be launched into a self-reinforcing downtrend.)

 vicious circle


Is there evidence the yen is in “overshoot” territory?  Yes.  When will the trend change?  We do not know. This self-reinforcing process can run as long as new money is thrown at the trend.  But we could be getting close…

Purchasing Power Parity (or the Economist Big Mac Index), is a long-term measure of fundamental value.  According to the Big Mac Index from the end of December 2021, the yen was 42% undervalued against the US dollar—when the yen stood at 115.  Now the yen is at 130—even more undervalued.  For a G-7 currency, this represents an extreme undervaluation.

jpy vs usd

Though deficits are often used as reasons for a movement in the currency; it is not a trading tool.  But as a longer-term measure it can often suggest a change in trend is overdue when a country’s currency and current account are diverging.  Interestingly, in the two charts below there is divergence in the currency and current account for both the US and Japan. 

US Current Account Deficit vs. US Dollar Index

As you can see, the US current account deficit (gold line) is growing rapidly (surging into all-time high territory), while the US dollar (purple line) is rising—quite a divergence is developing in these price series.