The potential impact of a Fed rate cut on the pair is a critical issue for investors and currency strategists, especially as we approach a potential Fed rate cut in 2024.
With the Fed and the Bank of Japan’s divergent monetary policies, market participants are divided on whether interest rate cuts by the Fed will weaken the USD/JPY pair.
According to analysts at Bank of America, the relationship between Fed rate cuts and USD/JPY is more nuanced, with a variety of structural and macroeconomic factors at play.
Contrary to popular market expectations, the relationship between a Fed rate cut and a weakening USD/JPY is not certain.
Historically, the USD/JPY has not always fallen during Fed easing cycles. The main exception was during the global financial crisis of 2007-2008, when the decline in the yen carry trade caused the yen to appreciate significantly.
With the exception of the global financial crisis, interest rate cuts by the Federal Reserve, such as those seen during the 1995-96 and 2001-03 cycles, have not led to a significant decline in the USD/JPY pair.
This suggests that the broader economic context, particularly in the US, plays a crucial role in how the USD/JPY pair reacts to Fed rate moves.
Bank of America analysts point to a shift in capital flows into Japan, which reduces the chances of a sharp appreciation in the yen in response to interest rate cuts by the Federal Reserve.
Japan’s foreign asset investments have shifted from foreign bonds to foreign direct investment and stocks over the past decade.
In contrast to bond investments, which are highly sensitive to interest rate differentials and the carry trade environment, FDI and equity investments are more driven by long-term growth prospects.
As a result, even if interest rates in the US fall, Japanese investors are unlikely to repatriate their money in large numbers, limiting upward pressure on the yen.
Moreover, Japan’s demographic challenges have contributed to continued outward FDI, which has proven largely insensitive to U.S. interest rates or exchange rates.
These continued capital inflows are creating a structural downward pressure on the yen. Individual investors in Japan have also increased their exposure to foreign equities through mutual funds (tochins), a trend supported by Japan’s expanded Individual Savings Account (NISA) scheme, which encourages long-term investment rather than short-term speculative flows.
“Without a sharp downturn in the US economy, interest rate cuts by the Fed may not be fundamentally positive for the yen,” analysts said.
The risk of continued US balance sheet recession remains limited, with the US economy expected to achieve a soft landing.
In such a scenario, the USD/JPY pair is likely to remain elevated, especially since interest rate cuts by the Fed are likely to be gradual and moderate, based on current expectations.
Expectations of three 25bp rate cuts by the end of 2024, rather than the more than 100bp that the market is pricing in, support the view that USD/JPY could remain strong despite the easing of US monetary policy.
Japanese life insurance companies, which have historically been major participants in foreign bond markets, are another key factor to consider.
While the high cost of hedging and bearish expectations for the yen have prompted long-term investors to reduce their hedging ratios, this trend limits the potential for the yen to rise if the Fed cuts interest rates.
Moreover, life prisoners have reduced their exposure to foreign bonds, as public pension funds drive much of Japan’s overseas bond investments.
These pension funds are less likely to react to short-term market fluctuations, further reducing the likelihood of the yen appreciating.
While Bank of America remains bullish on USD/JPY, there are some risks that could change its trajectory. A recession in the US is likely to lead to a more aggressive series of rate cuts by the Fed, which could push USD/JPY down to 135 or lower.
However, this would require a significant deterioration in US economic data, which is not the base case for most analysts. Conversely, if the US economy accelerates again and inflationary pressures persist, the USD/JPY pair could rise further, possibly retesting the 160 level in 2025.
Risks from the Bank of Japan’s policy changes are less significant. Although the Bank of Japan is gradually normalizing its ultra-easy monetary policy, Japan’s neutral interest rate remains well below that of the US, meaning that Fed policy is likely to have a greater impact on USD/JPY than the BOJ’s move.
Moreover, the Japanese economy is more sensitive to changes in the US economy than vice versa, which reinforces the idea that Fed policy will be the dominant driver of the USD/JPY pair.
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