Summary
The dollar strengthened across the board as the market was forced to revise expectations that the May FOMC would mark a final rate hike and that rates could be reduced at an early date. The FOMC is likely to leave rates unchanged at the June meeting given Fed Chair Jay Powell seems to favor an end to rate hikes, but the Fed has kept open the option of further hikes in the future. Regardless of the outcome, the dollar is likely to remain strong for some time if the FOMC does not declare that it has finished raising rates at the June meeting. Meanwhile, now that the BOJ has decided to maintain YCC, the nature of the policy means the Bank has little choice but to continue with dovish communication until the next meeting. We expect a policy change to be announced with the release of the outlook report, which means July at the earliest, and see a continued risk of yen depreciation until then. However, we see a ceiling of around JPY145.00 given that Japanese authorities are taking a restraining stance.
May in review
The USD/JPY opened the month at 136.43. The BOJ left policy unchanged at its end-April monetary policy meeting and Governor Kazuo Ueda's subsequent press conference was also seen as dovish, putting the USD/JPY on an uptrend at the start of the month. On 1 May, the USD/JPY rose to the mid-137 yen level for the first time since 8 March. It then fell back on 2 May following a weaker than expected US job openings and labor turnover survey. The FOMC on the 3 May raised rates by 25bp but did not announce an end to its rate hikes. However, Chair Powell's dovish press conference resulted in the USD/JPY falling to a low of 133.50 early on 4 May. The USD/JPY recovered to the 135 level on 5 May following a strong US payrolls report, but continued to hover around this level for a while as Japanese investors came back from the long holiday at the start of the week. The dollar strengthened after the University of Michigan survey announced on 12 May showed long-term inflation expectations at a 12-year high, pushing the USD/JPY beyond 135.50. The pair rose intermittently with almost no pull back after that. US new jobless claims and the Philadelphia Fed index beat market expectations on 18 May, pushing the 2y UST yield up to the 4.2% level for the first time since April. The USD/JPY also renewed its March high, reaching the 138 level. The pair briefly treaded water around this level before rising to 139 on 24 May after the UK CPI sharply beat market expectations, sparking a rise in Gilt yields that worked to push up UST yields. The USD/JPY then rose to around 139.50 in response to Fed Governor Christopher Waller's refusal to rule out the possibility of another rate hike at the June FOMC meeting. The pair briefly fell back to the upper 138 level early on 25 May after a major rating agency noted the possibility of a UST ratings downgrade, but quickly rebounded. The USD/JPY then swept past 140 after US GDP data and new jobless claims beat market expectations. President Joe Biden and Republican House Speaker Kevin McCarthy struck a deal on the debt ceiling issue at the end of that week, and the USD/JPY briefly fell back below 140.00 on 30 May after the end of the long weekend in the US. However, the pair subsequently rose back to 140.93 as a weakening of the Chinese yuan due to concerns about the Chinese economy spilled over to the Australian dollar, euro, and the yen. Immediately after that, the Japanese authorities announced a three-party information exchange meeting between the Ministry of Finance, the Financial Services Agency, and the BOJ. The USD/JPY fell sharply in response, and continued to fall to below 139.50 on the 31 May with the dollar also weakening due to a decline in UST yields (Figure 1).
Dollar rises across the board due to revision of US monetary policy outlook
At the time of writing this report, the USD/JPY in May had ranged from a low of 133.50 on the 4th to a high of 140.93 on the 30th, with a largely one-sided strengthening of the dollar against the yen. The US is facing the thorny issue of the federal government debt ceiling, but despite this, the Fed has stuck to its hawkish stance as numerous economic indicators point to a solid economy, tight labor supply/demand, and sticky inflation. This has forced us and other market participants to revise the outlook for the terminal rates and the timing of interest rate cuts, and as a result, the dollar has risen across the board in the foreign exchange market. In addition, in Japan, the expected rate of inflation is rising due to the recent acceleration in inflation and the improvement in business confidence after the COVID-19 pandemic. Meanwhile, the BOJ's YCC policy is holding down nominal rates, resulting in a decline in real interest rates in Japan, making it easier for stock prices to rise and the yen to weaken. However, an overview of G10 currencies during this period shows that the yen is positioned in the middle group amidst the overall strength of the dollar (Figure 2). That said, we see simmering expectations for monetary policy normalization and the trade deficit is shrinking. The environment is slightly different from last year, when the yen weakened across the board due to the disparity in domestic and foreign monetary policies and the trade balance worsened. In addition, the return to the JPY140 level for the first time since November 2022 has suddenly heightened the sense of caution about overheating. The Ministry of Finance, the Financial Services Agency, and the BOJ held a three-party meeting on 30 May which was generally interpreted as a means to "rein in the currency markets in the face of the yen's continued slide" (as reported by a commercial broadcaster).
Furthermore, at the time of writing this report, the US federal debt ceiling issue seemed to be heading toward a conclusion. The outcome is uncertain, and we see the risk of large swings in the USD/JPY over the short term.
FIGURE 1: USD/JPY (DAILY)
Note: As at 16:00 JST on 31 May
Source: EBS, MUFG
FIGURE 2: MAJOR CURRENCIES' RATE OF CHANGE VS USD IN MAY
Note: As at 16:00 JST on 31 May
Source: Bloomberg, MUFG
Fed has not announced end of rate hikes
Based on the forecasts of FOMC participants (the dot plot) in December and March, we and most other market participants had expected a terminal rate (upper limit of the FF rate) of 5.25% in the current phase of US rate hikes, which started in 2022. We expected the focus would then shift to the timing of the start of rate cuts. However, we have been forced to revise our assumptions (Figure 3).
The FOMC in May raised the federal funds rate target range by 25bp to 5.00%–5.25%. This clears the terminal rate we had been expecting to date. The FOMC statement removed the section that said it expects some additional policy firming would be appropriate, which could be seen as opening the path for a halt to rate hikes. However, it also added wording that left open the possibility of future rate hikes, and at least did not go as far as to say outright that this would be the final rate increase. Employment data for April, released after the FOMC, showed that the loosening of tight labor supply/demand conditions had stalled, and the CPI showed a slowdown in the pace of decline in the inflation rate (Figure 4). In response, Fed Governor Michelle Bowman said, "the most recent CPI and employment reports have not provided consistent evidence that inflation is on a downward path" and "should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate." After that, some high-ranking officials who are not necessarily hawkish have made remarks that do not rule out further rate hikes. According to the minutes of the FOMC meeting in May, which were released later, if the banking-sector stress seen since March subsides, economic activity will become more resilient, and upside risks to prices will increase. In this case, participants felt the core inflation rate would probably not fall as much as expected. Regarding monetary policy decisions from the next meeting onwards, several participants (6-7) were in favor of a pause, and some (4-5) in favor of resuming interest rate hikes from July. Chairman Powell suggested that he favored keeping interest rates unchanged (WSJ), while Fed Governor Christopher Waller has refused to rule out a hike in June, showing that opinion on the issue is split even among high-ranking officials.
The FF interest rate futures market is now factoring in the possibility of an additional rate hike at the FOMC meeting on 13-14 June, given the fading concerns about banking-sector stress and no notable moves to tighten credit at present. That said, we cannot go so far as to say that concerns about the financial system have been resolved at present. Given that the federal funds rate has already been raised to a fairly tight level, we expect the FOMC will put off raising rates in June and that the current target rate of 5.00%–5.25% will end up as the terminal rate. However, recent communications by senior Fed officials suggest that even if the FOMC does not raise rates in June, it could still hint at a hike in July depending on key indicators such as employment data for May and the CPI, and there is a possibility that the dot plot could also be revised upward. To date, we have seen a gap between the Fed's communication and the outlook of the financial markets regarding monetary policy. While the Fed itself may also revise its outlook (dot plot) upwards, the financial markets, which around April had factored in an interest rate cut as early as September, are being forced to revise their outlook. At the time of writing this report, we have factored in a high probability of further interest rate hikes by July, but also the possibility of a rate cut starting in November. Regardless of the outcome, the circumstantial evidence so far suggests that it will take time for the Fed to revise its stance of not considering a rate cut this year. We therefore still see room for the market to revise its outlook. This suggests that the dollar will remain strong for some time, and a risk of a further rise in the USD/JPY.
US federal debt limit issue comes to a head, outlook highly uncertain
Naturally, this outlook is highly uncertain. In the short term, it is unclear how the US federal debt limit issue will pan out. Currently, the federal government could run out of cash by 5 June. The White House and Republican controlled House of Representatives had been unable to reach a compromise, resulting in warnings from major credit agencies about a possible UST rating downgrade. The price of superlong USTs with maturities of 30 years or more softened (yields rose), and the foreign exchange markets saw a move to risk-off dollar buying. Then over the long weekend just before writing this report, President Biden and Republican House Speaker McCarthy agreed in principle to suspend the debt limit for the next two years in exchange for some spending cuts, with the decision now in the hands of Congress. As a result, the dollar weakened as investors unwound risk-off moves on 30 May, which was the start of the week in the US. Risk-off dollar strength will fade further if the debt ceiling bill passes through the Congress as is. However, some hardliners in the opposition Republican Party have expressed opposition to the bill. It is difficult to say with certainty that the bill will be passed by the House of Representatives at the vote scheduled for 31 May. In other words, there is still the possibility of a default, which the Treasury has warned about. In that case, we would have to assume that dollar selling will intensify against the yen.
FIGURE 3: FOMC PARTICIPANTS' MEDIAN FED FUNDS RATE OUTLOOK
Source: Fed, MUFG
FIGURE 4: US CPI (YOY)
Source: Bureau of Labor Statistics, MUFG
Inflation pressures could be persistent
Meanwhile, in Japan, the BOJ's dovish communication continues. As Governor Ueda has acknowledged for some time, the YCC, which is the basis of current monetary policy, sets a permissible range of long-term interest rate fluctuations. Therefore, the Bank has to buy an unlimited amount of JGBs if the interest rate looks likely to exceed that range (on the upside). This makes it difficult to give advance notice of policy changes. The BOJ decided to maintain policy settings at its most recent meeting, meaning that it will have to continue communications based on the assumption that the policy will be continued at least until the next meeting.
In May, Governor Ueda had many opportunities to speak, including lectures, parliamentary statements, and joint media interviews. In each cases, his stance seemed to be based on maintaining the status quo, leading the financial markets to conclude that there will be no policy changes for the foreseeable future. In addition, in order to maintain the YCC, the BOJ has moved to deter short selling of JGBs through a scheme called the Securities Lending Facility (SLF). This creates a difficult environment for trades betting on policy revision (= abolition of YCC), which are mainly made by overseas investors. Due to these factors, even with US interest rates rising, long-term rates in Japan continue to fall short of the YCC's de-facto upper limit of 0.50%. At first glance, this may suggest that the distortion of the yield curve has been smoothed out.
Meanwhile, inflation continues to accelerate. Preliminary Tokyo CPI for May showed a slight slowdown in headline and core (excluding fresh food) inflation to +3.2% YoY. However, growth in core-core inflation (excluding fresh food and energy), which the BOJ watches for underlying price trends, accelerated to +3.9% (Figure 5). This suggests that the BOJ will need to quickly revise up its forecasts for FY23 average core inflation growth of +1.8% and core-core growth of +2.5% made in the April outlook report. Against this backdrop, the expected inflation rate is rising in financial markets, as evidenced by strong demand at the 10y inflation-indexed bond auction conducted by the MOF on 23 May. As a result, real yields on 10y JGBs, for example, have fallen significantly, eroding the increase following the BOJ's move to raise the YCC's yield cap to 0.5% in December, and this is partly encouraging the yen to weaken (Figure 6).
"Weak yen curb" begins
Meanwhile, the three-party meeting held on 30 May suggests that the government is concerned about yen weakness. The weakening yen could put further pressure on gasoline prices to rise given the government's decision to accelerate the pace of reductions in gasoline price subsidies from June. Considering that individual subsidies were being used to pay for gasoline, the acceptance of a weak yen from this point on is likely to cause import prices to rise again ahead of a possible dissolution of parliament. Incidentally, the same three-party meeting was held on 10 June last year, when the USD/JPY had risen to around 134. At that time, quite a few market participants thought actual exchange rate intervention would not be possible. However, it is safe to assume that current market participants, who watched all this play out, regard the holding of this meeting itself as a way to curb exchange rate movements. We also see the possibility that a second and third arrow will be fired as necessary.
However, we currently do not expect the BOJ to change its policy at the monetary policy meeting on 15-16 June in response to the yen's ongoing slide. Governor Ueda has said that he will review the materials necessary for monetary policy decisions at each meeting, but has repeatedly explained that the medium-term outlook is important for the normalization of monetary policy. Based on what the BOJ has said to date and given the official stance that monetary policy does not aim to influence the foreign exchange market, we expect the BOJ to move to change policy along with the release of the outlook report. This means a change in course would come in July at the earliest. The BOJ will therefore have to maintain its dovish communication for at least the next two months, which will increase the sense of disparity between monetary policy in Japan and overseas. This means the environment is likely to remain reassuring for yen sellers but conversely also hold the prospect of the government stepping into curb exchange rate moves.
FIGURE 5: TOKYO CPI (YOY)
Source: MIC, MUFG
FIGURE 6: 10Y JGB YIELD AND YEN NEER
Source: Bloomberg, MUFG
Raising forecast range, but risk of yen-led slide
The dollar started weakening against the yen on 21 October 2022. However, we had expected the divergence in perceptions between US authorities and the financial markets in particular to result in numerous swings. This panned out as we expected, but we did not anticipate having to revise our terminal rate assumption, meaning the swing back was also unexpectedly strong.
The USD/JPY has already broken above our forecast upper limit of 140.00 once. As we have seen to date, it is difficult to conclude that this will be the upper limit in the short term. From the perspective of charts, a return to the high of 142.25 on 22 November last year could be a temporary target. However, a break past this point would bring 145.00 into view, partly because there was a sharp decline at the time. We have therefore concluded that it is necessary to raise the upper limit of our forecast range.
However, fiscal tightening in the US is likely to be strengthened once the issue of the federal government debt ceiling has run its course. Considering this, we expect debate to center around whether there will be at most one more interest rate hike going forward. We therefore see little room for UST yields to rise. Also, once a ceiling comes into view, the focus of the financial markets will likely return to the question of the timing of interest rate cuts. In that regard, the interest rate differential between Japan and the US was wider than it is now when the USD/JPY lost momentum just below 138.00 in March. In other words, the USD/JPY is already overshooting if we consider only the difference in interest rates. The stance of the Japanese authorities also makes it hard to imagine that the yen will rise further and reach the JPY150 level again.
Rather, we see the risk of a sharp decline in the USD/JPY going forward. The financial markets currently expect the BOJ to maintain the status quo for the foreseeable future, but the Bank could surprise by shifting gears sooner than expected. Governor Ueda has said that the outlook for prices in the second half of the fiscal year is considerably more uncertain than in the first half. This could also be interpreted as suggesting the Bank will revise up its outlook sometime soon. Also, attention tends to have focused on wages in relation to the outlook for prices, but Ueda said that wages themselves are not the target and that in a situation of sustained and stable inflation of 2%, wages should naturally be rising. We think this implies that changes in monetary policy do not need to be tied to confirming wage trends in FY24. Ueda has also said he is fully aware that the rise in prices to date has imposed a considerable burden on all citizens. He has repeatedly said that the rise in prices is due to supply-side factors, but having said this much, many will probably be questioning the consistency of current policy with Article 2 of the Bank of Japan Act which states that "the Bank of Japan conducts currency and monetary control, aiming at achieving price stability, thereby contributing to the sound development of the national economy." In any case, although the Bank says it will remain firmly in easing mode, amid signs of a structural labor shortage, Governor Ueda himself must be skeptical about the need to continue monetary easing through the current framework which has been strengthened over the past ten years. Therefore, while his basic stance is dovish, he does not rule out the possibility of normalization in the future, and sometimes makes remarks that are taken as new hints. Overseas factors and domestic factors such as the possibility that the government will dissolve the lower house and trigger a general election are probably making it difficult for the BOJ to act, but we see every possibility that the Bank will soon start the process of shifting from unprecedented monetary easing to a more normal form of easing, starting with ending YCC in July. With a US rate cut still some time away, we therefore expect the BOJ will play a leading role in pushing down the USD/JPY over the next few months.
QUARTERLY FORECAST RANGE AND PERIOD-END FORECAST
|
Jun 2023 |
Jul-Sep |
Oct-Dec |
Jan-Mar 2024 |
|
|
USD/JPY |
135.0～145.0 |
129.0～145.0 |
127.0～143.0 |
125.0～141.0 |
|
Period-end forecast |
138.0 |
133.0 |
131.0 |
129.0 |
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.
