NLI Research — Weekly Economist Letter: Rapid Yen Appreciation

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In its “Weekly Economist Letter” from early September, the NLI Research Institute analyzes the recent rapid appreciation of the Japanese Yen against the US Dollar, identifies the factors driving this trend, and provides a detailed outlook for the future of the USD/JPY exchange rate.

1. Recent Yen Appreciation: A Shift from Historic Lows

The report begins by highlighting the dramatic shift in the USD/JPY exchange rate. After reaching a historic high of 161 yen to the dollar in early July 2024, the yen has since experienced a significant appreciation, trading around 142 yen to the dollar at the time of writing. This represents a 20 yen appreciation from its peak, indicating a substantial shift in market sentiment.

2. Key Drivers of Yen Appreciation: Unraveling the Factors

Several interconnected factors are identified as contributing to the yen’s resurgence:

• Japanese Government Intervention: The report points to the Japanese government’s intervention in the currency market in mid-July, purchasing an estimated 5.5 trillion yen, as a significant catalyst. This intervention not only provided direct support for the yen but also served as a warning to market participants about potential further action, contributing to the unwinding of speculative yen selling positions.
• Shifting Interest Rate Differentials: The divergence in monetary policy between the Bank of Japan (BOJ) and the US Federal Reserve (Fed) has been a crucial factor influencing the USD/JPY exchange rate. However, recent events have led to a narrowing of this interest rate differential, diminishing the attractiveness of carry trades (borrowing in yen to invest in higher-yielding US dollar assets). The BOJ’s unexpected rate hike in late July, coupled with signals of a potential dovish pivot by the Fed, fueled expectations of further narrowing, contributing to yen strength.
• Emerging US Recession Concerns: Growing concerns about a potential US recession have also played a role in bolstering the yen, considered a safe-haven currency during times of economic uncertainty. Weak US economic data, including the ISM Manufacturing Index and employment figures, amplified these concerns, further supporting the yen.

3. Mechanics of Appreciation: Understanding the Market Dynamics

The report delves deeper into the specific market mechanisms driving the yen’s appreciation:

• Shrinking Interest Rate Differentials and Carry Trade Unwinding: The attractiveness of carry trades, a major driver of yen weakness, hinges on a substantial interest rate differential between Japan and the US. However, the narrowing of this differential, driven by the BOJ’s rate hike and the prospect of Fed rate cuts, has led to a significant unwinding of these trades, fueling yen buying.
• Shifting Speculative Positioning: Data from the Commodity Futures Trading Commission (CFTC) reveals a sharp decline in net short yen positions held by speculative investors. This suggests a shift in sentiment, with investors unwinding their bearish bets on the yen, further contributing to its appreciation.
• Relative Yen Strength in G20: Comparing the yen’s performance against other G20 currencies reveals its significant relative strength. The report attributes this to a combination of the factors mentioned above, highlighting the yen’s unique position in the current global economic environment.

4. Future Outlook: Navigating Uncertainty with a Baseline Scenario

Looking ahead, the report acknowledges the inherent uncertainty surrounding future economic developments, particularly regarding the US economy. The baseline scenario assumes a soft landing for the US economy, with a gradual slowdown rather than a full-blown recession. This scenario has several implications for the USD/JPY exchange rate:

• Continued Gradual Yen Appreciation: The report anticipates the yen to continue appreciating against the US dollar, albeit at a more moderate pace compared to the recent rapid surge. This is primarily attributed to the expectation of further narrowing of the interest rate differential between the US and Japan.
• Factors Limiting Rapid Appreciation: Several factors are expected to prevent a sharp and uncontrolled yen appreciation. Firstly, the unwinding of speculative short positions, a major driver of the recent surge, is considered largely complete. Secondly, the market has already priced in a degree of Fed rate cuts, limiting the potential for further surprises. Lastly, persistent structural factors, such as Japan’s trade deficit and capital outflows, are expected to continue exerting downward pressure on the yen.
• Forecasts and Potential Risks: The report projects the USD/JPY exchange rate to reach 143 yen to the dollar by the end of 2024 and 136 yen to the dollar by the end of 2025. However, it acknowledges that a more severe US economic downturn, leading to aggressive Fed rate cuts, poses a significant risk to this outlook. In such a scenario, the USD/JPY rate could potentially fall below 120 yen to the dollar.

5. Navigating Political Uncertainties: Japan and the US

The report acknowledges the potential impact of upcoming elections in both Japan and the US on the USD/JPY exchange rate:

• Japanese Election: The upcoming election for the President of the Liberal Democratic Party (LDP) in Japan could impact the BOJ’s monetary policy stance. While a significant shift in the BOJ’s policy direction is considered unlikely, the new leadership’s stance on the BOJ’s independence and the pace of policy normalization could introduce a degree of uncertainty.
• US Presidential Election: The outcome of the US Presidential election holds significant implications for the USD/JPY exchange rate. A potential victory for former President Trump, particularly if coupled with a Republican-controlled Congress, could lead to increased market volatility due to his unpredictable policy stances. A victory for Vice President Harris, on the other hand, is expected to result in greater policy continuity, minimizing market disruptions.

6. Conclusion: A Path Dependent on Global and Domestic Forces

In conclusion, the report highlights the complex interplay of factors influencing the USD/JPY exchange rate, with a particular focus on US economic conditions and the monetary policy divergence between the Fed and the BOJ. While the baseline scenario anticipates a gradual yen appreciation, it emphasizes the potential for significant volatility stemming from unexpected economic developments and political uncertainties in both Japan and the US.

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