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The Japanese yen was under downward pressure for most of 2023, with its descent picking up steam over the third quarter as the Bank of Japan’s steadfast ultra-accommodative stance diverged from the rise in interest rates across the rest of the developed world. However, the winds of supportive change have started to blow. Views that the major central banks have reached their respective interest rate peaks, and that policy in Japan may finally start to be normalised, have given the exchange rate a boost. We think this is only the start and expect the still-undervalued currency to outperform over 2024.





















The Bank of Japan is playing aggressive catch up.

In our opinion, relative interest rate differentials should continue to shift incrementally in the yen’s favour over the next year. While central banks appear set to maintain restrictive policy settings to ensure inflation is tamed, we doubt further interest rate hikes will be delivered. Indeed, with central banks evolving toward a more data-dependent and risk management-focused approach as growth slows, labour markets loosen, and inflation moderates, expectations about the next easing cycle should intensify. This is likely to see bond yields outside of Japan decline as in past cycles, when rates have fallen once it became clear the monetary tightening phase had passed, growth worries were rising, and central banks were preparing to ease policy.

US bond yields and Federal Funds rate, %

Japan’s nominal gross domestic product growth is running over 6 percent, wage gains have started to quicken, and core inflation (i.e., excluding fresh food and energy) is tracking near 4 percent (approaching its fastest pace since the early-1980s), meaning significant monetary policy normalisation may be on the horizon. In our opinion, it is a matter of when, not if, the Bank of Japan formally jettisons its now largely-defunct yield curve control framework and moves interest rates into positive territory. We think steps are most likely to be taken in the January to April 2024 period. We feel this sea change could generate yen-positive capital flow dynamics as Japanese investors potentially begin allocating less offshore and/or repatriating capital back home given the more attractive local returns on offer after accounting for FX hedging costs. The further officials go, the larger the potential yen upside.

Hedged yields from Japan-based investor perspective, %

A more bearish backdrop for the yen might unfold if the Bank of Japan holds firm, ignoring elevated inflation and indications that price growth could persist. In this scenario, wide interest rate differentials should continue to depress the yen: especially if risk sentiment remains buoyant, inflation cools, and global growth slows whilst avoiding more sinister outcomes.

USDJPY and Japan Trade-Weighted Index

While yield spreads in absolute terms look set to remain skewed against the yen for some time, we believe the bulk of the adjustment has played out. The balance of probabilities is tilted toward differentials narrowing and the yen recovering further. As other central banks, such as the Federal Reserve, European Central Bank, and Bank of England, contemplate a policy easing cycle, the Bank of Japan appears set to embark on a normalisation path. Modest tweaks, such as the formal ending of yield curve control, may well see markets discount larger steps further out. We are projecting the yen to drift down to 140 in first quarter, before moving towards 130 by end-2024. Our bullish bias also means that following a torrid spell we expect the yen to outperform on the crosses.

USDJPY and US-Japan yield spreads

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