The Weakening Yen and the Outlook for Major Currencies: A Foreign Exchange Analysis

[Tokyo 2il]- A weaker yen has become evident from 2022 onwards. Comparing the rates of change in the nominal effective exchange rates (according to the Bank for International Settlements, Broad Standard) for 10 major currencies, in descending order of strength the Swiss franc, the US dollar, the euro, the pound British, the Australian Dollar, the New Zealand dollar, the Canadian dollar, and the Swedish krona, the Japanese Yen was the lowest, followed by the Norwegian krone.

With the exception of the Swiss franc, which has repeatedly intervened to buy its own currency in order to prevent inflation, more than 80% of this rate of change can be explained by the range of changes in the real policy interest rate.

For example, the real policy interest rate for the Yen fell from -0.6% (YCC short-term interest rate – year-on-year change in Composite CPI) at the end of January 2022 to -2.9% by November 2023. . The Yen is the only country where the real policy interest rate has fallen and is still in negative territory. This is arguably the Yen’s biggest weakness.

The Bank of Japan is likely to end negative interest rates in early 2024. However, the likelihood of an additional rate hike necessary for the real policy interest rate to move into positive territory is not high. This is because imported inflation, the so-called “first force,” will weaken, making it difficult to see that the price stability target will be reached sustainably.

It is true that Japanese companies, facing the first labor shortage in 30 years, have no choice but to focus on securing employment through wage increases, and there is increasing pressure on prices to accompany wage increases, or the “second force,” is likely to continue. to some extent..

However, in terms of labor productivity, which is the main source of wage growth, Japan ranks only 30th out of 38 member countries of the Organization for Economic Co-operation and Development (OECD). The sustainability of wage rises after 2025 is uncertain, and the Bank of Japan is likely to be cautious about normalizing monetary policy. Additional interest rate rises in 2024 will be limited to a single increase of 10bp or 25bp, and the real policy interest rate is likely to remain in negative territory.

Add to this the pressure on the Yen to weaken in the international balance of payments, such as the structurally entrenched trade deficit and foreign direct investment that remains at a high level, and the Yen may be forced to weaken at the bottom of the major currencies. . .

Next, I will summarize the current situation and outlook for the dollar. In conclusion, I believe that the dollar will not weaken that much and will remain at or above the mid-range among the 10 currencies. Let’s look at the three reasons below.

First, there is a high possibility that the market is currently pricing in an excessive amount of US interest rate cuts. For current market expectations for interest rate cuts to materialize, it will only make sense for interest rate cuts to be implemented at every FOMC meeting for the rest of the year, starting with the Market Committee meeting US Federal Open (FOMC) in April 2024.

However, US employment statistics for November showed that while the labor force participation rate rose, the unemployment rate fell. The number of job openings for unemployed people has also fallen from its peak to 1.3 times, but it is still higher than before the coronavirus. The number of new applicants for unemployment insurance also remains low. Although the workforce population is on the rise and the supply and demand situation in the labor market is expected to ease, it is unlikely that the unemployment rate will rise sharply enough to demand cuts in interest rates six times a year. It is likely that the rate cuts will have to be revised over time, giving the US dollar some room to recover.

Second, it is hard to imagine that long-term interest rates in the United States will continue their downward trend. As long as the labor market maintains some resilience, the decline in consumption is likely to be limited.

The rise in stock prices, reflecting favorable interest rate cuts, also supports consumption through the wealth effect. House prices are expected to bottom out in early 2023, and this could ultimately be a factor pushing prices up through an increase in imputed rents. As a result, the fall in inflation from now on will be limited and will prevent long-term interest rates from falling.

Also, attention should be paid to the decline in supply and demand for US bonds. Quantitative tightening by the US Federal Reserve, the largest holder of US debt, will continue at a rate of $60 billion per month, at least until interest rates are cut. Given the rise in yen bond yields and currency hedging costs, the second largest Japanese holders are not in a position to actively accumulate US bonds.

China, the third largest country, held about $1.3 trillion at its peak in 2013, but its holdings have continued to fall, standing at $769.6 billion in October.

Under these circumstances, the US Budget Office (CBO) in its latest economic forecast released in December predicted long-term interest rates of 4.8% at the end of 2024. Although this is indeed high, I believe that long-term interest rates in the United States in 2024 remains in the high range of 3% to about 4%. Among developed countries, the US dollar has the highest interest rates after the Australian dollar and the New Zealand dollar, so there will be limits to the dollar’s depreciation.

Finally, there is the depreciation of the euro/dollar. Unlike US inflation, which is driven by service prices and wages, goods dominate inflation in the euro area. As a result, inflation is falling faster than in the US, and year-on-year growth in the core consumer price index in November was 3.6%, slower than in the US, compared to 4.0 % in the United States. Comparing business confidence using the Composite PMI, the Eurozone is significantly lower at 47.0, compared to 51.0 in the US.

Furthermore, fiscal restructuring is expected to gradually begin in the euro area starting in 2024, increasing the need for interest rate cuts to prevent the economy hitting rock bottom. The ECB’s (European Central Bank) hawkish stance will not last long and there is a high possibility that it will switch to interest rate cut mode in early 2024.

The euro/dollar pair is expected to remain strong in the short term due to expectations for interest rate cuts in the US, but this is unlikely to be sustainable and is likely to remain weak thereafter. The dollar index (DXY) has never fallen in a year when the euro/dollar exchange rate, which has the most volume in the foreign exchange market, has fallen throughout the year.

Based on the above, we will consider the main scenario for the dollar / yen. US long-term interest rates won’t fall that much, and the dollar will be in the upper middle range among major currencies. On the other hand, as Japan’s real policy interest rate remains in negative territory, the Yen is likely to remain stagnant in the lower tier, and the dollar/yen pair is likely to remain firm.

Viewed in chronological order, the dollar/yen pair is likely to be looking for a low price in the first quarter, with expectations for a US interest rate cut and expectations that the Bank of Japan will raise its negative interest rate . We should expect the price to drop to around 135 yen at most.

On the other hand, as time passes, expectations for US interest rate cuts will need to be revised. Add to this the view that the pace of normalization by the Bank of Japan after raising negative interest rates will be slow, and the dollar/yen pair is expected to rise, reaching a maximum of 140 yen. However, compared to 2023, the difference in interest rates between Japan and the US will narrow somewhat, so the potential for the price to rise above 150 yen will fade. It is expected to remain between 135 yen and 150 yen throughout the year.

Finally, we will present a risk scenario. If concerns about US inflation resume and expectations for interest rate cuts all but disappear, or if the Bank of Japan’s decision to raise negative interest rates is delayed until the second half of the year, the dollar pair/ yen is likely to break higher than the interest rate. expected range.

In particular, the US presidential election could be a disruptive factor. If the government moves towards large-scale fiscal expansion after the election, we will probably see an appreciation of the dollar similar to the “Trump rally” in 2016.

On the other hand, if the US economy closes in and the market cuts interest rates more than expected, or if the Bank of Japan becomes more hawkish than expected, the dollar pair / yen breaks below the expected range.

However, in light of the current US economy and the stance of the Bank of Japan so far, the likelihood of a stock price breaking below this range is lower than a scenario where it breaks above it.

Editing: Kazuhiko Tamaki

*This article was published on Eikon from LSEG (London Stock Exchange Group) on December 27th. Based on information up to the same date.

(This column was posted on the Reuters Foreign Exchange Forum. It is written based on the author’s personal opinion)

*Mr. Minoru Uchida is an associate professor in the Faculty of Commerce at Takachiho University and a foreign exchange analyst at FDA Alco. After graduating from Keio University, he joined the Bank of Tokyo (currently Mitsubishi Bank UFJ). He has worked in market operations and served as chief foreign exchange analyst from 2012 to 2022. Current position since April 2022. In J-money magazine’s Tokyo foreign exchange market survey, he is ranked No. 1 in the individual position for nine consecutive years since 2013. International Certified Investment Analyst, Securities Analyst Member of the Journal Editorial Committee, Visiting Researcher at the International Monetary Institute, Master of Economics (Kyoto Sangyo University).

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* The content of this article is based on information at the time of writing.

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