Summary
Rate hikes by the Fed have entered a final phase due to financial system instability caused by bank failures. The Fed's hawkish stance of raising rates for ‘higher and longer’ has softened, sapping momentum from the USD/JPY's swing back toward 140. However, the dollar may regain strength if the Fed maintains rates after it ends its hiking cycle because the market is pricing in an early rate cut. Meanwhile, Kazuo Ueda will take the helm at the BOJ in April. YCC may be revised or abolished. In addition, expectations that the BOJ will end its negative interest rate policy could grow if the inflation outlook is revised upward in the outlook report. We continue to expect the USD/JPY to trade in a wider range.
March in review
The USD/JPY opened the month at 136.37. A deterioration in the DI of bond market functioning in the BOJ's bond market survey released on 1 March and expectations of policy revisions at Governor Haruhiko Kuroda's final monetary policy meeting pushed the USD/JPY down to the low 135 level. However, the USD/JPY rose to 137.90 on 8 March, the highest level since 15 December last year, on the back of a strong ISM and other US economic indicators and hawkish comments by Fed Chair Jay Powell at his testimony before congress on 7-8 March. The USD/JPY then fell back on 9 March due to concerns about the outflow of deposits from US regional banks. The pair rallied briefly on 10 March after the BOJ left policy on hold at its monetary policy meeting, but then slid to the 134 level because some aspects of US employment data missed market expectations. The market shifted risk-off after some US regional banks failed over the subsequent weekend. The USD/JPY continued to fluctuate around the 134 level, but then dropped to around 131 as concerns about the financial system hit banks in Europe, leading to a rescue merger between Swiss financial institutions which made some subordinated debt (AT1 bonds) worthless and ramped up risk-off sentiment. The FOMC raised rates by 25bp, despite rumors of a temporary pause, partially because the ECB had hiked by 50bp the previous week. However, the statement on monetary policy and other releases suggested that the Fed had softened its aggressive stance on monetary tightening. The USD/JPY fell all the way to 129.65 on 24 March due to the uncertain response from authorities in the US, where the crisis started, and a sharp decline in European bank stocks. However, concerns about the financial system receded after the authorities decided on a plan to rescue the failed bank that weekend. The USD/JPY also rebounded, rising to the 132 level on 29 March and briefly touching the mid-133 level on the 31st. It was trading above 132.5 at the time of writing this report (Figure 1).
Concerns about the financial system triggered by a series of US bank failures temporarily strengthened dollar buying in a move away from risk, but the subsequent revision to expectations that the Fed would continue raising rates for higher and longer resulted in the dollar weakening when viewed over the whole month. Meanwhile, risk aversion has held back the currencies of resource-rich countries, with notable weakness in the AUD and CAD (Figure 2).
FIGURE 1: USD/JPY (DAILY)
Note: As at 14:00 JST on 31 March
Source: EBS, MUFG
FIGURE 2: MAJOR CURRENCIES' RATE OF CHANGE VS USD IN March
Note: As at 14:00 JST on 31 March
Source: Bloomberg, MUFG
US rates to fall, dollar to weaken due to financial system concerns
In early-March, the USD/JPY tested the 140 mark as expectations that the gap between monetary policy and interest rates in Japan and the US would widen again drove carry trade like yen selling and dollar buying. However, the atmosphere changed completely due to the spread of concerns about the financial system. The USD/JPY fell to the 129 level at one point due to growing expectations that the Fed would be unable to continue tightening since this had precipitated the bank failures. Concerns about the financial system eased towards the end of the month because authorities tightened regulations and took other measures to address the crisis and in the absence of concerns about other financial institutions emerging. As a result, the USD/JPY rallied back to the 133 level on 31 March.
Fed turns dovish after realizing it overlooked signs of bank failures
Two banks with similar business models failed shortly after it was reported that an outflow of deposits was creating a crisis for emerging regional banks. US authorities tried to solve the issue by taking a special measure to guarantee all deposits at the failed banks, but uncertainty about whether such guarantees could be extended increased concerns about the financial system as the market wondered what bank would be next. Market sentiment rapidly deteriorated as the contagion spread to Europe. However, the US authorities finally decided to rescue the failed banks and moved to consider expanding deposit protection and strengthening bank regulations. No new individual cases have surfaced, and concerns about the financial system have receded for now.
However, the Fed is expected to continue raising rates slightly, which contributed to the outflow of deposits in the first place, and we still see similar banks with low loan-to-deposit ratios and a bias toward securities investment on the asset side. US authorities also seem to be maintaining a state of vigilance. On 28 March, President Joe Biden said concern about the financial system was not over yet, and Minneapolis Fed President Neel Kashkari said the crisis would take some time to resolve. Authorities have set a 1 May target to review the circumstances that led to the bank failures, consider proposals for revising banking regulations and supervision, and carry out a comprehensive review of the deposit insurance system. We expect the US financial system to remain in a state of uncertainty at least until then.
The bank failures were partly due to a lapse in the Fed's oversight function, and this has had a profound impact on its monetary policy stance, with the Fed apparently having considered suspending interest rate hikes at the March FOMC. Chair Jay Powell's reaffirmation that the Fed would hike rates higher and for longer just two days before the bank failure shows just how blindsided the Fed was (= a failure in terms of supervisory function). Unfortunately, this occurred during the blackout period before the FOMC, which left the Fed in a tough spot because it would have to make a call in the absence of dialogue with the market. In addition, the ECB had only just announced that it would raise rates by 50bp. A decision to halt rate increases could therefore have led to the view that the financial system in the US was more of a concern than in Europe.
In the end, the FOMC decided to raise interest rates by 25bp, and dropped the phrase "ongoing increases" in rates from its statement, which was interpreted as a ‘dovish hike’. The federal funds rate forecast announced at the same time in the dot plot put the median forecast for the terminal rate at 5.125%, the same level as previously in December (Figure 3). Chair Powell said at a press conference that widening credit spreads due to financial system instability would have the effect of tightening monetary policy equivalent to additional interest rate hikes. An inverted interest rate environment is straining traditional banking businesses as well as failed banks. We do not expect the view that the Fed is poised to stop raising rates and shift to rate cuts will reverse anytime soon, meaning the yield curve is likely to remain inverted for some time. Given this, the response that the authorities are considering would probably amount to nothing more than a further increase in costs for most financial institutions, which are considered to be sound. Credit spreads have widened due to instability in the financial system,and may widen further (Figure 4). Several senior Fed officials who had the opportunity to speak after the FOMC meeting expressed similar views on this point. Considering that credit spreads are unlikely to narrow in the short term, we think it is safe to assume for now that the Fed will hike once more in May, as indicated by the dot plot.
Meanwhile, Chair Powell's press conference following the FOMC meeting and statements by senior Fed officials after that have repeatedly stressed that the Fed does not intend cutting rates within the year. The interest rate futures market continues to price in a rate cut in the second half of the year, even though concerns about the financial system are receding. We expect this divergence between the Fed and the market's view to encourage the USD/JPY to swing back again soon. St. Louis Federal Reserve Bank President James Bullard has indicated that financial system instability should be dealt with by strengthening oversight and that monetary policy should continue to deal with high inflation. Other senior Fed officials have also repeatedly emphasized the importance of curbing inflation, and it appears that FOMC participants are generally in agreement that the Fed will not shift to rate cuts for some time even if it halts further increases. Looking at the changes in the environment since the year before last and the Fed's response, we should keep in mind the Fed's current view is just that – and is prone to change. However, the data we have to date suggests that the Fed's position is unlikely to change in the period of one month – through April for example. We therefore see limited room for US rates to fall for now, and rather see potential for a rebound, which could put further upside pressure on the USD/JPY in the near term. Of course, looking out over the medium term through next year, it would be reasonable to assume that the Fed will shift from halting further hikes to a cycle of rate cuts. The market could also put pressure on the Fed to cut rates sooner if employment data and the CPI fall below market forecasts in the near term.
FIGURE 3: MEDIAN OF FF RATE FORECASTS AT LAST YEAR'S FOMC MEETING
Source: Fed, MUFG
FIGURE 4: CREDIT SPREADS (FRA-OIS SPREAD)
Source: Bloomberg, MUFG
New BOJ regime first looking to revise or abolish YCC
The new BOJ regime will finally kick off in April. Governor Haruhiko Kuroda will step down on 8 April, with Kazuo Ueda taking the helm on Monday 10 April. Ueda's inaugural press conference is scheduled for the same day (probably in the evening) and is likely to be a major touchstone. The first monetary policy meeting under the new leadership is scheduled for the end of April. We expect the new BOJ Governor will take the opportunity to express his views at the press conference, bearing in mind the policy decisions to be made. Deputy governors Ryozo Himino and Shinichi Uchida have already taken office, but did not conduct the press conferences that are, by convention, supposed to be held on the day of their appointment. This might have been because when the two deputy governors took their positions on 20 March, the BOJ also issued a statement early in the morning that it would provide dollar funds jointly with major central banks. The two deputy governors have already made statements to the Diet once. However, we cannot help but suspect that there is something intentional about the lack of press conferences. Perhaps, the BOJ plans to hold a joint press conference with the new governor and two deputies along with the inauguration of Governor Ueda.
Governor Ueda's challenge for the next five years is likely to be the normalization of monetary policy. The economic policies of the Kishida administration up to this point have shown a desire to break away from a policy regime focused on ending deflation, having concluded that the ten years of Abenomics after 20 years since the bursting of the bubble economy has failed to deliver higher wages. The centerpiece of this move will be a shift away from the monetary policy that symbolizes Abenomics, and the government has chosen Governor Ueda for that purpose. As a starting point, we expect the BOJ will consider revising or abolishing the YCC framework, which controls (holds down) long-term interest rates. The functionality of the bond market has been damaged by the continuation of YCC amid the global acceleration of inflation and rising interest rates since the year before last. The corporate bond issuance environment has deteriorated over the last six months, indicating that side effects have spread not only to financial markets but also to corporate activities. At his confirmation hearing before the Diet in February, Ueda said that YCC has caused various side effects. When asked whether the YCC should be reviewed, he replied that he saw many possibilities but refrained from commenting on anything specific at the hearing. On the other hand, when asked if YCC should be firmly maintained, he said only that he planned to assess the impact of various measures from December onwards. This suggests Ueda believes monetary easing is necessary, but that the Bank does not need to stick with YCC. We therefore expect the BOJ to debate whether it is necessary to continue with the YCC, which was introduced after QQE failed to produce the desired effects.
The Bank could move to end YCC quicky given the decline in market functionality, meaning it could introduce policy revisions as early as the meeting on 27-28 April. Recently, upward pressure on interest rates around the world has weakened and speculative moves in anticipation that YCC will be abolished have also subsided. Long-term interest rates are no longer stuck at the de facto upper limit of 0.50%, and interest rates would probably not jump higher even if the BOJ ended YCC now. The increase in yield target band in December 2022 was interpreted as a de facto interest rate hike based on past remarks by BOJ executives. Since we expect the BOJ under Ueda's leadership will consider continued monetary easing to be appropriate, it will probably want to avoid a repeat of this kind of assessment. In this regard, even if the Bank abolished YCC in the current environment, it would not lead to an immediate increase of market rate, and it would be difficult to see it as a de facto rate hike, meaning it would be a good opportunity to revise the policy. However, the decline in interest rates was caused by worries about the financial system, and the BOJ is working with other central banks to curb such concerns. The shift in policy from unprecedented monetary easing to a tighter monetary policy has a different implication than the fact that the Fed and ECB have continued to raise interest rates so far. In addition, the Fed's review of bank failures in the US and its responses to the situation are set to conclude by 1 May, which could make it difficult to enact policy changes at the meeting in April. In that case, we think the BOJ could wait until the next meeting in June.
We expect to see a glimpse of moves toward policy normalization even if policy revisions are postponed at the April meeting. The Bank will publish its quarterly Outlook report (the Bank's view) at this meeting. In the most recent Outlook Report in January, the core-core CPI (excluding energy and fresh food), which the BOJ has long focused on in observing underlying price trends, is forecast to grow 1.8% YoY in 2023 and by 1.6% in 2023. If this is revised higher and growth was not expected to fall below 2%, given the focus on the 2% inflation target, we expect Ueda would not only revise or abolish the YCC, but also consider moving short-term rates out of the negative. Headline inflation and core inflation (excluding fresh food) has been declining since February due to government subsidies for electricity and gas bills, but core-core inflation continues to rise. Tokyo CPI data for March, announced on 31 March, showed a further acceleration in the core-core figure (Figure 5). In addition, this year's spring wage talks (Shunto) resulted in a wage increase exceeding 3% on average, including at small and medium-sized enterprises (Figure 6). We see the possibility that wage increases could be sustained to some extent considering the increasing sense of labor shortages as economic activity picks up following the end of pandemic-related restrictions. This suggests the outlook for inflation could shift to not expecting a fall below 2% sometime soon, even if not in April.
Ueda's remarks at confirmation hearings and elsewhere suggest he is unlikely to rush to normalize monetary policy immediately after taking office. In particular, we think changes in short-term rates are likely to be some time off. However, we think he will steer the ship toward policy normalization, and the prospect of a narrower divergence in monetary policy with the US over the medium term is likely to be seen as a yen strengthener in the near term.
FIGURE 5: TOKYO CPI (YOY)
Source: MIC, MUFG
FIGURE 6: WAGE HIKES FROM SPRING WAGE SETTLEMENTS
Source: RENGO, MUFG
Maintaining a wide forecast range
We think the current phase of monetary tightening is finally approaching its end given that the Fed's rate hikes were partly to blame for the bank failures in the US and the growing concerns about the financial system. The USD/JPY rebound since February turned out to be a temporary reversal, confirming our view that dollar weakening and a stronger yen is the major trend. We maintain this view but note that the Fed and the market have a wildly different outlook for US monetary policy, and this could result in a sharp reversal similar to the JPY10-plus swing at the beginning of March. On the other hand, the yen could strengthen due to risk aversion if concerns about the financial system grow again. In addition, attention is likely to focus on the BOJ's monetary policy under the new leadership from April. Speculative moves could also push the Bank to revise YCC again. We also see the possibility that the yen could drive sharp fluctuations in the USD/JPY, with potential flashpoints being Governor Ueda's inaugural press conference on 10 April and subsequent dialogue with the market. We continue to maintain a wide forecast range in light of such factors.
QUARTERLY FORECAST RANGE AND PERIOD-END FORECAST
|
Apr-Jun 2023 |
Jul-Sep |
Oct-Dec |
Jan-Mar 2024 |
|
|
USD/JPY |
124.0～140.0 |
122.0～138.0 |
120.0～136.0 |
118.0～134.0 |
|
Period-end forecast |
129.0 |
127.0 |
125.0 |
123.0 |
Our forecast range estimates the high and low for each quarter. The period-end forecast is our forecast for USD/JPY at 17:00 New York time at the end of each quarter.
