The Japanese yen (JPY) has had a turbulent year on foreign exchange markets. In the first six months of the year, the yen depreciated by over 12% and was one of the worst performing major currencies anywhere in the world, reaching its weakest levels against the US dollar in around four decades.
Several reasons have been cited for the yen’s decline. One is sluggish export numbers in Japan, which have reduced demand for the yen and contributed to its decline. But perhaps more important is the large – and ongoing – interest rate differential between Japan and the US. While rates have now started to come down in the States, earlier this year interest rates were as high as 5.5% as the Federal Reserve continued to battle post-coronavirus inflation.
The Bank of Japan made a historic pivot earlier this year by finally ending Japan’s regime of negative interest rates, but at 0.1%, there remained a huge gap between rates in the US and Japan. This naturally incentivised foreign exchange traders to rotate assets out of Japan and into the US in order to benefit from the significantly higher yields on offer.
However, as we head into 2025, are there signs that things are looking up for the Japanese yen? Just today the yen briefly strengthened past the symbolic 150 yen/dollar mark as higher than expect inflation numbers led traders to speculate that the Bank of Japan will be forced to raise interest rates further in 2025.
Indeed, earlier this week it was announced that Tokyo’s core consumer price index (CPI), rose by 2.2% compared to the previous year, a higher rate of price rises than most analysts had expected. Partly because of this, Japanese swaps markets have been pricing in a strong chance that the Bank of Japan will raise interest rates in December – markets suggest there is about a 60% chance of this happening next month.
This is significant for USD/JPY markets because the States has recently embarked on a cycle of monetary easing. In October, the Federal Reserve cut rates to a 4.5-4.75% range and most traders expect further cuts to be announced in December. Markets are currently pricing in a further two cuts for 2025. This means that the interest rate differential between US and Japanese markets is likely going to narrow, potentially encouraging traders to shift some of their assets out of the US and into Japan.
Derren Nathan, equity research at Hargreaves Lansdown, said in a note to clients that these “opposing monetary conditions either side of the Pacific” have pushed the yen up past the 150 mark. “Markets are now pricing in over a 60% chance that headline interest rates will be raised at December’s meeting in Tokyo. That’s in stark contrast to continuing hopes of a US rate cut in December.”
Jaideep Tiwari, global head of foreign exchange strategy at Citi Wealth, has predicted that the dollar-yen cross rate could hit the mid-130s in 2025 on account of these dynamics. However, he added that “we need to see that yield compression between the Fed funds and the Bank of Japan overnight rate by at least about 200 funds” for this to transpire.
Some analysts remain sceptical as to whether this period of yen strengthening can be sustained. Shoki Omori, a strategist at Mizuho Securities, said that “markets are overreacting to Tokyo CPI results” and suggested that algorithmic trading strategies had artificially driven the yen higher. “Looks like algos kicked in and took this “headline opportunity” to short dollar-yen,” he said.
Much will also depend on how strong the US dollar will perform under the incoming Trump administration. Many analysts expect the dollar to strengthen as a result of Trump’s policies around tariffs, which are predicted to raise the cost of imported goods in the States, contribute to higher inflation, and therefore keep rates higher. There are several unpredictable dynamics at play in USD/JPY markets as we head into 2025.
Author: Harry Clynch
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