Yen should recover despite near-term volatility

Mark's monthly letter: That butterfly effect (3:12)
Our CIO Mark Haefele on investing through new complexities in global markets.

The Japanese yen held its gains against the US dollar on Tuesday, after suspected intervention by Japanese authorities sparked a sharp rise. At around 156 against the USD at the time of writing, the yen has strengthened from as low as 160.1 at one point on Monday. Japan’s top currency diplomat Masato Kanda declined to comment on the finance ministry’s role in the price jump, but said authorities were ready to deal with foreign exchange matters around the clock.

From a historical perspective, FX interventions tend to have a short-lived impact, and the fundamental picture for the Japanese yen remains challenging in the short run. Officials from the Federal Reserve indicated that rates may need to stay higher for longer, while the Bank of Japan (BoJ) signaled little urgency for further policy tightening despite the removal of the negative interest rate policy in March. Persistently low rates domestically have driven Japanese investors overseas for higher returns, and the yen has been used as a funding currency for carry trades.

We believe near-term volatility in the USDJPY rate is set to remain elevated amid US dollar strength, especially as markets respond to the Federal Reserve’s policy meeting this week. But in our base case, we continue to expect the currency pairing to top out and move lower as the year progresses.

The BoJ could hike rates in July if yen weakness persists. The Japanese central bank last week kept monetary policy settings unchanged, signaling the need to continue an accommodative financial environment to support economic growth and price stability. However, it revised the inflation outlook upward. With this year’s substantial negotiated wage increases and a weak currency feeding through the economy, we think the likelihood of the BoJ responding with a rate hike in July has increased. The country’s latest consumer price index showed that underlying inflation remains solid, particularly in the services sector.

We see limited scope for further repricing of Fed rate cuts, barring US data beats. The futures markets are currently only pricing in 35 basis points of Fed rate cuts by the end of December, down from as much as 160bps at the start of this year. While recent US inflation prints have been higher than expected, overall softer economic conditions should help to ease inflationary pressure this year. Our base case remains a soft landing, with US economic growth and inflation cooling off as consumers pause after a long period of strong spending. This should allow the Fed to cut rates twice this year, starting in September. The Fed’s easing should help drive a narrowing of US-Japan yield differentials and push USDJPY toward our year-end target of 148.

FX intervention makes it less attractive for speculators to push JPY weaker. While there was no confirmation on government intervention, Japanese officials have been issuing regular warnings since mid-April. In our view, not intervening at all would create the risks of greater costs at a later stage for Japanese policymakers. With speculative net-short JPY positioning reaching levels not seen since 2007, a staunch defense from authorities could encourage some trimming of short-yen trades.

So, while we do not rule out the possibility of a risk case scenario where USDJPY reaches 170–180 if there is a loss in currency confidence or the Fed signals further rate hikes, we believe the currency pairing is more likely to trade with elevated volatility in a wide range between 145 and 160.

The near-term potential for USDJPY to fall significantly below 150 looks limited considering the latest economic data. Unless the macro backdrop changes, investors may use any short-term large USDJPY pullbacks (toward 150) to re-establish long USDJPY positions. For investors with a manageable amount of yen exposure, we suggest retaining their holdings to position for a longer-term recovery toward 148 by year-end. From a risk-management perspective, we would avoid adding short USDJPY positions, or selling the risks of USDJPY rallying for yield pickup, before the exchange rate’s upward momentum eases off. But for investors looking to build up long JPY positions over the next 12–24 months, we see value in selling volatility in the crosses such as EURJPY, GBPJPY, or CHFJPY for yield, in light of more imminent probable rate cuts in Europe.