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, %