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Even after a recent rally, the Japanese yen holds the distinction of being the second worst-performing G10 currency year-to-date. With markets beginning to question whether US rates have peaked, the role of monetary policy expectations in driving the exchange rate has diminished, but could snap back in the event that the Bank of Japan begins responding to growing inflation pressures in a more decisive manner.

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Risk / reward balances are shifting in the yen’s favour.

It was one-way traffic for the Japanese yen in the back end of the second quarter. The currency depreciated sharply against a range of other majors, with the US dollar touching a 7-month high, the Australian dollar hovering around the top end of its 9-month range, and the euro hitting its highest level since the third quarter of 2008.

Markets were clearly underwhelmed by the lack of action at the late-April Bank of Japan meeting, the first for newly-appointed Governor Ueda. Over the same period interest rate expectations for other major central banks like the Reserve Bank of Australia, Bank of England, and Federal Reserve have risen, to differing degrees, due to persistent inflation pressures, and this has seen yield differentials tilt in an unfavourable direction. However, we think things may have moved too far. Given where the yen is now trading, we think the distribution of medium-term outcomes has become increasingly uneven. Put simply, we see more upside than downside risks from here.

Widening rate differentials pose a threat.

Countering long-standing market consensus, the Bank of Japan could remain cautious, maintaining its ultra-accommodative policy stance in the face of quickening domestic inflation. A renewed rise in energy prices might generate a negative currency shock via a renewed deterioration in the country’s flow dynamics. Alternatively, an extended run of stronger-than-expected global activity data – potentially paired with persistently-sticky inflation – could lead to a widening in interest rate differentials (although we note that the likely negative implications for global growth and risk appetite could act to limit the extent of any yen weakness in markets).

World industrial indicators and Japanese yen

Japan remains a rock in a sea of troubles.

In our view, a bullish scenario for the yen (against the dollar and other majors) might unfold if the developing global economic downturn becomes more pronounced, with the negative feedback loop into markets larger and broader than anticipated. Periods of heightened financial stress are typically supportive for the currency as Japanese investors tend to repatriate capital allocated overseas during market turbulence.

Another yen-positive development could emerge if the Bank of Japan surprises and normalises its policy settings more quickly and abruptly than envisaged. We would note that market expectations for a change at any time soon appear low. More assertive steps from the central bank, especially at a time when other major central banks look to be nearing the end of their respective tightening cycles, could encourage greater inflows into Japan, and discourage offshore allocations by Japanese investors.

We have a positive medium-term bias and expect the yen to strengthen over the third quarter and subsequent quarters. We see the currency rising towards 130 by year-end, and into the mid-120’s in a year’s time. This stems from several factors including: (a) Our expectation that the Bank of Japan will embark on a policy normalisation path given the upturn in inflation. Core inflation (all items excluding fresh food and energy) is now running north of 4 percent per annum, the highest since 1981. In our judgment, an ultra-accommodative stance appears untenable, and it seems to be a matter of when, not if, the Bank jettisons its yield curve control or negative interest rate regime. The odds a policy tweak is made as soon as the meeting have picked up. (b) The turnaround in Japan’s trade and balance-of-payments positions and terms-of-trade on the back of the lower oil price; and (c) Slowing global growth and outlook for more bouts of market volatility. This is normally a favourable setting for the Japanese yen.

Core inflation rates, annual % change