Japanese Yen falls to 38-year low. What’s next?

What happened?

Since March 2022, the US Federal Reserve has been on a tightening mode. The result is that most major currencies have depreciated against the US dollar. 

A basket of the US major trade partners' currencies has depreciated by 6% against the US dollar.

Of note here however is the significant depreciation of the Japanese yen which has weakened by more than 20%. 

This surpasses the declines observed in other Asian currencies where fundamentals appear to be even weaker than Japan. 

Just this week, the Japanese Yen fell to its weakest level against the US dollar since 1986.

We delve into the reasons behind the sharp drop in the Japanese yen.

What is driving weakness in the Japanese Yen?

#1 - Interest rate differentials

First, is the interest rate differentials, or carry to use the technical term. 

Notably, it is the 10-year US Treasury (UST)- Japan Government Bond (JGB) rate differential that matters. 

Over the past three years through 2 June 2024, this differential explained over 90% of movements in the USD/JPY exchange rate.   

However, it seems like this differential is unlikely to narrow anytime soon. 

The US economy shows no signs of an impending recession in contrast to the view in 2023. 

According to the latest labour statistics, the US created 272,000 jobs in May 2024. With the strength in the US economy, the Fed may not be in no hurry to cut rates for now. 

By contrast, the BOJ may remain cautious and is likely to look for more evidence of a sustained recovery in domestic demand before going for more aggressive normalization. 

A pivot against BOJ’s low interest rate regime remains a long way from bolstering the yen.

In short, the differential will persist, discouraging any large scale flow of funds from the US back to Japan. 

#2 - Stagnant wage growth in Japan

The second reason which is related to the first is that real wage growth in Japan has stagnated since 2000. 

This anemic wage growth is the key reason why Japan has been in deflation and has pushed the BOJ to pursue its ultra loose monetary policy. 

While inflation hawks may point to the recent 5.3% wage hike by Japan’s largest employers during this spring’s wage negotiations (the biggest since 1991), it remains to be seen whether this move will be followed by the small and medium sized corporates. 

The latter are far bigger employers of Japanese workers. 

There may be a need for a more sustained wage hike to translate into stronger inflation to prompt the BOJ to raise rates. 

In the meantime, what this means is that Japanese rates will remain low holding back the yen.

#3 – US Dollar retains its safe-haven status

For most investors, the tightening cycle by the Fed is often cited as the key reason for the strong US dollar and by extension weaker currencies for most countries. 

Less well known but equally important is that US investors’ appetite for foreign equities and bonds has been declining in the last two years. 

In 2021, US portfolio investment abroad (comprising equities, bonds, mutual funds, ETFs) amounted to USD711b but fell to USD347b in 2022 and just USD372b in 2023, according to the US Bureau of Economic Analysis.

By contrast, foreign appetite for US assets have stayed at robust levels, reaching USD1.2 trillion in 2023 against USD614billion in 2021. 

The dollar benefits from its safe-haven status. Amidst two on-going wars in the Ukraine and in the Middle East, investors have flocked into the safety of the US dollar denominated assets. 

This is despite the talk of de-dollarisation and fiscal challenges faced by the US government. 

What to look out for next?

#1 – Inflation in Japan

According to the BOJ governor the yen’s weakness thus far has not had an impact on underlying inflation in the country. 

Japan’s Core Inflation moderated to 2.2% in April 2024 from a peak of 4.2% in January 2023.

Notably, Prime Minister Kishida has also warned that it is premature to declare deflation as over for Japan despite the BOJ’s 2 per cent inflation target has been exceeded in the past two years.

This may suggest that the BOJ now has a higher threshold for a weak yen. 

#2 – Intervention by Japanese Central Bank

Any intervention to strengthen the yen is also unlikely to provide lasting support to the yen if the wide gap between US and Japanese interest rates persists. 

To tackle deflation effectively a period of sustained yen weakness is essential.

#3 – Oil prices 

Over the past 12 months there has been an exceptionally high degree of correlation between oil prices and the yen. 

This is not surprising as higher oil prices has exacerbated the yen’s decline given Japan’s overwhelming dependence on Middle East oil.

What would Beansprout do?

Since the Fed began hiking interest rates in March 2022, the Japanese yen has recorded the biggest decline among major currencies. 

Following the BOJ’s decision to keep its policy rate unchanged on 26^th April, the yen weakened past 156 yen to the USD. 

To keep track of where the Japanese Yen might be headed next, we will be keeping a close look-out for the Fed’s interest rate direction, action taken by the Japanese Central Bank as well as oil prices. 

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