The Japanese yen (JPY) has been one of the worst performing major currencies in 2023. Higher US bond yields and unwinding of market expectations of a more hawkish BoJ policy have been the primary drivers for the yen’s underperformance. We believe markets expectations have now run ahead of reality, offering investors with 12-24-month horizon a rare opportunity to add exposure to the JPY. Here, we highlight three potential catalysts which could push the USD/JPY pair towards 120-125 range. Such a move would translate into double-digit returns for JPY investors.
Interest rate differentials to turn from headwind to a tailwind
While most currency pairs tend to show strong correlation with short-term (usually 2-year) interest rate differentials, USD/JPY stands out – the pair has a strong relationship with 10-year nominal interest differential between US and Japan in the post-pandemic era.
Over the past few weeks, the 10-year rate differential has widened on the back of rising US government bond yields as financial markets sharply reduced their expectations of Fed rate cuts over the next 12 months due to hawkish commentary from Fed policymakers amid stickier-than-expected US inflation data. This has pushed USD/JPY pair higher (or the yen weaker).
Nevertheless, we know that markets often tend to overreact to shifting narratives. The current spike in US bond yields appears to be another case of a knee-jerk overreaction from investors. While US inflation has proven to be stickier than expected, we cannot ignore that the US economy is slowing down as we start to see the lagged impact of 500bps of Fed rate hikes over the past 15 months. Hence, we expect the US to enter a mild recession by Q4 of this year. If this scenario plays out as we expect, the Fed is likely to begin cutting rates by the end of the year as it tries to avoid a deep recession. Consequently, we expect US government bond yields to decline modestly over the next few months, eventually dipping below 3% by March 2024. This should drive interest rate differentials between the US and Japan lower, pushing USD/JPY lower (or yen stronger).
Fig 1: Lower Interest rate differentials to drag USD/JPY lower
USD/JPY and difference between 10-year US and Japanese government bond yields
Source: Bloomberg, Standard Chartered
BoJ to reverse easy money policy
In Figure 1 above, between January and April 2023, USD/JPY traded weaker than the level implied by the interest rate differential. This deviation from fundamentals was largely due to markets building-in expectation of a gradual reversal of the Bank of Japan’s (BoJ) monetary policy, from years of maintaining an extreme dovish bias to a more hawkish tilt, as inflationary pressures rise.
However, since the BoJ’s April meeting, when new Governor Ueda pushed back against any imminent change in the monetary policy, markets have largely priced out the likelihood of policy tightening in the near term. While the strong pushback from the BoJ came as a surprise to markets, we believe the pressure on the central bank to ultimately scrap its extremely dovish Yield Curve Control (YCC) policy and return Japan’s benchmark interest rates back to positive territory remains in place.
Japan’s economic growth appears to be robust and the latest round of ‘shunto’ wage negotiations indicate an average wage growth of over 3%. Rising wage pressures suggest Japan’s above-target inflation may not decline sharply over the next 12-18 months and return to target as the BoJ expects. Additionally, it is well known that many years of bond buying by the BoJ has impacted the smooth functioning of domestic bond markets, adding to the list of reasons why it makes sense for the BoJ to scrap its Yield Curve Control policy (where the BoJ buys governments bonds to suppress yields). Any potential sign of a shift in the BoJ policy could act as a catalyst for a sharp move lower in USD/JPY.
Valuations not a hinderance for JPY gains
Over the past decade, the JPY has consistently screened as cheap versus most other major currencies in most currency valuation models. At present, based on various indicators, the JPY appears to be 20-30% cheap relative to its fundamentals. While valuations alone are usually not a strong enough catalyst to drive major currency moves, the fact that the JPY is one of the cheapest currencies means that when the stars align, valuations would not be an obstacle to a large move.
Implications for investors
Timing the markets, especially currency markets can be notoriously difficult. However, given the confluence of positive catalysts outlined above, investors with a 12-24-month investment horizon may have an attractive opportunity to add exposure to the JPY. Also, our investment committee recently turned Overweight on Japanese equities among global equity markets in our foundation asset allocation. This implies investors now have an attractive opportunity to deploy their JPY holdings into Japanese equity markets.
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