JPY Monthly - March 2023

Summary

Expectations of an end to Fed rate hikes faded following the announcement of better-than-expected US employment and CPI data. Speculation over the appointment of the next BOJ governor ended with news that Kazuo Ueda, who has been dovish up till now, has been chosen to take the helm at the BOJ. The USD/JPY rose beyond 136 as the dollar strengthened across the board and the gap between monetary policy in Japan and overseas came into focus. This undid the strengthening of the yen following the BOJ's revision to YCC in December 2022. We expect the market to now focus on the extent of rate hikes at the March FOMC and the outlook for the federal funds rate. Employment and CPI data announced before this could spark a further rise in rates and strengthening of the dollar. We revise up our forecast for the USD/JPY now that market expectations for US monetary policy have been pushed back.

February in review

The USD/JPY opened the month at 130.12. The FOMC raised rates by 25bp on 1 February, as the market had expected. However, at the press conference following the decision, Fed Chair Jay Powell said he thought disinflation was in its early stages and that he expected two more rate hikes. The dollar weakened in response to his comments and the USD/JPY fell to 128.08 on 2 February. However, it rallied back to the 131 level on the 3rd after the US payrolls report showed nonfarm payrolls well ahead of the market's forecast. On Monday, 6 February, news about the appointment of the next BOJ governor helped push the pair up to 132.90. The USD/JPY fell back on the 7th after Fed Chair Jay Powell said he expects a significant decline in inflation this year. News that Kazuo Ueda had been picked as the next BOJ Governor on 10 February saw the USD/JPY fall to the upper 129 level, but it then recovered to above 131 as Ueda's comments that the Bank should maintain current policy settings erased the initial reactionary decline, and the University of Michigan survey announced on the same day showed a rise in inflation expectations. The USD/JPY rose intermittently after that, moving above 135 on 17 February as the US CPI announced on the 14th beat market expectations, the rise in UST yields accelerated, and the dollar strengthened. It treaded ground for a time at this level, before rising to around 136.5 following BOJ Governor nominee Kazuo Ueda's confirmation hearing in the lower house on the 24th and the acceleration of inflation shown in the PCE deflator announced on the same day in US trading hours. The USD/JPY had fallen to below 136.5 at the time of writing this report (Figure 1).

February saw a revision in the outlook for US monetary policy and an across-the-board strengthening of the dollar. Kazuo Ueda's dovish comments during his confirmation hearings brought the disparity in monetary policy between Japan and overseas back into view, and the yen weakened against other major currencies as well (Figure 2).

FIGURE 1: USD/JPY (DAILY)

Note: As at 13:00 JST on 28 February

Source: EBS, MUFG

FIGURE 2: MAJOR CURRENCIES' RATE OF CHANGE VS USD IN FEBRUARY

Note: As at 13:00 JST on 28 February

Source: Bloomberg, MUFG

Dollar strengthens across the board in February, yen weakens somewhat on news of BOJ Governor pick

The USD/JPY rose by over 8 yen in February, from a low of around 128 to around 136.5. The monthly candles formed a white candlestick for the first time in four months. This mainly reflected the change in the outlook for US monetary policy in the financial markets. The view rapidly took hold that the Fed's rate hike cycle would be ‘higher and longer’ than had been expected. The appointment of a new BOJ Governor also likely played a part. However, we think it is too early to conclude that the widening disparity in monetary policy between Japan and the rest of the world was behind the dollar strength and yen weakness, as had been the case through October last year.

Ceiling for US rate hikes to rise, but unlikely to be stripped away

The outlook for US monetary policy changed following the announcement of various statistics in February which confirmed the labor market remains tight, inflation pressure has not abated, and that the economy did not slow unexpectedly. January nonfarm payrolls data announced on the 3rd had a major impact in this regard, with the 517,000 MoM rise much higher than the 260,000 gain in December and the market's forecast of a 189,000 increase. The unemployment rate also fell to 3.4%, which seemed to run counter to the spate of staff layoffs at tech companies and financial institutions. In addition, January CPI data announced on the 14th rose 6.4% YoY, only slightly slower than the 6.5% growth in December. The disinflation that top Fed officials began to talk about around the end of the year already seems to be losing steam. Retail sales and consumer spending data for January also showed consumption was firm, and the PCE deflator showed inflation accelerating. Over that period, top Fed officials said they thought a 50bp hike at the FOMC meeting in February was appropriate and that the upper limit of the FF rate target range should be set at 5.50%. Fed Vice Chair Lael Brainard, a prominent dove, resigned from the Fed to head the National Economic Council (NEC). Debate at the Fed is therefore likely to become increasingly hawkish. The financial markets accordingly revised the scenario to date that expected the FOMC would stop hiking rates at the May meeting and start cutting rates within the year.

At the start of February, the 10y UST yield had fallen to the 3.33% level for the first time since September 2022. It turned higher following the announcement of employment data and has recently reached the 3.97% level, approaching the key 4% mark. The FF futures curve has also shifted higher overall (Figure 3). This suggests a rise to the upper 5.5% level as a ceiling in August. It appears that the outlook for an end to the Fed's rate hike cycle and the start of rate reductions has been pushed back by one to two quarters. The dollar strengthened in line with this revision in the outlook for interest rates.

Some argue that the FF rate needs to be raised to the 6% level because the US economy looks set for a "no landing" scenario, rather than the hard landing that had been feared or the soft landing the Fed was aiming for. Amid this, the FOMC meeting on 21-22 March is drawing an increasing amount of attention. Some observers expect the Fed to reaccelerate the pace of hikes with a 50bp increase, although this is not the consensus. The FOMC will also release its quarterly summary of economic projections (SEP) and update the near-term FF rate outlook (Figure 4). Currently, the market consensus seems to be that the terminal rate will be 5.50%, and that the Fed will end its hiking cycle in June. However, the forecast for the terminal rate could be raised and the timing for an end to rate hikes and the start of rate reductions shifted back depending on economic indicators such as February employment statistics (10 March) and the CPI (14 March), which will be announced before the FOMC. In that case, the 10y UST yield is likely to again reach the 4% level and the dollar could strengthen further. Fed Chair Powell said on 7 February that inflation is starting to slow but he expects a long, bumpy road ahead. The Fed and the markets seem to have leaned too far into the idea of disinflation, even though it should have been widely known that demographic trends make solving the labor shortage a tough task, meaning the path to curbing inflation would be a long one. The markets seem to currently be in a phase of swinging back from this.

That said, imputed rent, which is currently pushing up YoY CPI growth, will decline with a lag of several months. Given that actual rents have already fallen considerably, we do not think it is necessary at this point to change our view on slowing inflation. In addition, according to BOJ governor nominee Kazuo Ueda, the impact of changes in monetary policy should be felt in six months at the earliest, and two or three years at most. Considering that the downward pressure on the economy due to rapid and substantial monetary tightening is now in full swing and based on the cumulative impact of rate hikes to date, we do not think considerations of monetary policy have shifted from estimating the timing of an end to rate hikes to again assuming rate hikes will continue. In that regard, US long-term interest rates may test the 4% level in the near term, but we expect a downward turn again over the next few months.

FIGURE 3: FF FUTURES

Source: Chicago Mercantile Exchange, MUFG

FIGURE 4: MEDIAN OF FF RATE FORECASTS AT LAST YEAR'S FOMC MEETING

Source: Fed, MUFG

New BOJ regime is more dovish than we expected

Meanwhile, the picks for BOJ governor and deputy governor positions, which were expected to be the main drivers of the USD/JPY during the month to the beginning of February, were announced. Kazuo Ueda was nominated for the position of governor, with Ryozo Himino and Shinichi Uchida as the deputy governors. Confirmation hearings were held in both houses of parliament in February, and the positions are expected to be approved going forward. The Nikkei published an article on 6 February claiming that the government had asked Deputy Governor Masayoshi Amamiya to succeed Haruhiko Kuroda as governor. The article in the same week which the decision was expected to be made, resulted the financial markets had basically accepted that Amamiya would be picked. However, on the evening of 10 February, media companies all published the news that the government had chosen Kazuo Ueda to take the helm. The yen temporarily strengthened on this news because the market did not expect much of change in monetary policy under Amamiya, but Kazuo Ueda talked to the press soon after the news broke and said that the current policy settings were appropriate, and that monetary easing was necessary. He maintained the same stance at the subsequent parliamentary confirmation hearings and refrained from making any specific comments on policy revisions, including yield curve control (YCC). As a result, yen selling has become slightly more dominant in the foreign exchange markets. Meanwhile, in the bond market, the 10y JGB yield targeted by YCC continues to stick to the de-facto upper limit of 0.50% (Figure 5).

After being approved by the parliament, both deputy governors will take office in March, and Governor Ueda will take office in April. This will mark the start of a new BOJ regime. The confirmation hearings in both houses of parliament suggest that incoming Governor Ueda has a dovish view on inflation. He thinks the recent rise in inflation is due to temporary cost-push factors and expects inflation to fall below 2% around the middle of the next fiscal year. He therefore thinks the joint statement with the government in January 2013 and the YCC policy are appropriate and sees no need for revisions in the near term. However, he said he would not hesitate to move to an exit strategy depending on inflation conditions and the outlook. In this regard, he could be seen as drawing a clear line between the former regime's focus on maintaining the YCC policy and its effective shelving of the joint statement with the government to achieve 2% inflation as soon as possible by continuing to forecast that stable inflation of 2% would not be reached but not easing further.

At the confirmation hearing before the upper house, Ueda said that it is appropriate to continue with monetary easing while devising ways to adapt to the situation. The flexibility of the funds-supplying operations against pooled collateral introduced at the January monetary policy meeting succeeded in pushing down the swap curve as intended but has not worked to eliminate the yield curve distortions as was the original plan. Ueda said he would carefully assess the extent to which interest rate functions had recovered following revisions to YCC operations in December and January. However, inflation may not be a temporary phenomenon considering the deterioration in the external environment (such as the renewed upside pressure on US interest rates), the prospect of large wage increases (although with disparities between regions and industries) in the face of this year's spring wage talks, and the labor shortage brought on by a declining population (Figure 6). We do not expect a quick return to an environment in which the 10y JGB yield remains stably below the upper limit of 0.50% in these conditions. Ueda has only said that it is appropriate to maintain YCC at the moment but has not ruled out the possibility of revising it in the future. We expect he will at some point conclude that it will not be appropriate to stick to the current stance on YCC.

The change of BOJ governor for the first time in ten years has attracted a lot of attention from financial markets. In addition, the purpose of the confirmation hearings is to obtain the approval of the parliament. The government still has about two months to make a decision, and it would be difficult to calm any major turmoil stirred up in the market. As a result, Ueda is likely to have tried to play it as safe as possible in his answers to parliament. Naturally, we do not expect a shift to hiking interest rates as seen in other countries, and Ueda repeatedly said at the hearings "monetary easing is necessary." Instead, we look for a gradual shift from the BOJ's unprecedented monetary easing to a more ordinary form of easing. Partly from the perspective of diversity, we had expected the government to pick Yuri Okina, the managing secretary of Reiwa Rincho, as a candidate for deputy governor. We had therefore expected the new BOJ regime to base the management of monetary policy on the proposals of this council. In light of this, we will need to revise our outlook for the direction of the BOJ's monetary policy to a more dovish position.

We see the monetary policy meeting on 9-10 March as a potential risk in the near term. We are uncertain whether the final meeting of the Kuroda regime will be eventful considering the actions taken in December and January. Basically, we expect the Bank will maintain current policy settings, but cannot rule out the risk of raid yen weakening if the BOJ moves to implement some kind of normalization measures. Considering the functioning of the bond market and the increased cost of measures to keep YCC running, it would probably be better to respond as soon as possible. And we should also keep in mind the possibility of the current regime moving to end the extraordinary easing measures of its own accord or setting a target for policy normalization

FIGURE 5: JGB YIELDS

Source: Bloomberg, MUFG

FIGURE 6: CPI (YOY)

Source: MIC, MUFG

Clear swing back, revising up forecast range

Last month we revised down our forecast range due to expectations that the Fed would soon move to halt interest rate hikes and said that we saw reduced scope for the dollar to strengthen and the USD/JPY to pull higher in the near term. However, US economic indicators released in February ran counter to that view, and the USD/JPY clearly swung higher. In addition, the USD/JPY moved in a wide range during the month, indicating an environment conducive to continued volatility. We maintain our medium-term view that the Fed will halt rate hikes in the near future and consider reducing rates at some point but think the timing for this will be later than we previously expected. We have also revised up our forecast for the USD/JPY. A prolonged rate hike cycle in the US suggests a widening disparity between monetary policy in Japan and overseas, which was behind the sharp strengthening of the dollar and weakening of the yen last year. However, we expect stress on the JGB market due to the rise in US interest rates and a stronger dollar and weaker yen will encourage the new BOJ regime to revise its policy settings. We therefore do not expect the USD/JPY to trend higher and break past 140 again.

QUARTERLY FORECAST RANGE AND PERIOD-END FORECAST

	Mar 2023	Apr-Jun	Jul-Sep	Oct-Dec
USD/JPY	132.0～140.0	124.0～140.0	122.0～138.0	120.0～136.0
Period-end forecast	136.0	133.0	130.0	127.0

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.