JPY Monthly- September 2023

Summary

The dollar strengthened across the board as US interest rates rose due to a deterioration in UST supply/demand and a rosy economic outlook. Meanwhile, the BOJ only moved to increase the flexibility of YCC at its July board meeting, which constrained a rise in long-term JGB yields and continued to reassure yen sellers.  The USD/JPY temporarily rose to above 147. We expect the environment to remain unchanged in the near term and see the possibility that the USD/JPY will test last year's highs. However, we remain cautious of downside risk because the BOJ, which has already taken steps toward policy normalization, could be forced to take measures to curb yen depreciation in the face of mounting criticism in Japan about the weak yen.

August in review

The USD/JPY opened the month at 142.35. The pair rose to above 143 on 1 August along with a rise in UST yields, with the BOJ's extraordinary buying operation aimed at curbing the rise in long-term JGB yields following its monetary policy meeting on 28 July acting to encourage yen selling. It rose past 143 again on 3 August after the BOJ conducted an extraordinary fixed-rate purchase operation at 0.65% in response to a renewed rise in long-term JGB yields. However, the USD/JPY fell back to around 141.5 on 4 August due to a decline in European stocks, US economic data missing market expectations, and a mixed US jobs report. The USD/JPY remained firm at this level, then rebounded on Monday 7 August due to a recovery in global stock prices. It continued to rise after that, moving past 144 and 145 with little resistance along with the release of the US CPI and other data, and finally passed 146 on 16 August. Finance Minister Shunichi Suzuki and Vice Finance Minister for International Affairs Masato Kanda made comments aimed at curbing the yen's slide on the 15th, but to little effect. However, the USD/JPY became top-heavy with markets wary of the possibility of government intervention after the USD/JPY passed the level at which Japanese authorities intervened in the currency markets by selling the dollar and buying the yen in September 2022, and in light of some reports on 17 August suggesting that the Chinese authorities were taking a stronger stance on curbing the weakening of the yuan. The USD/JPY pulled back to around 144.5 on 23 August due to a deterioration in the US PMI and a decline in US interest rates following a smooth result to the 20y UST auction. However, a sense of caution ahead of Fed Chair Jay Powell's speech at the economic symposium in Jackson Hole over the weekend limited moves to chase downside and the USD/JPY rebounded to above 146.5 on 25 August. Powell's speech was uneventful and UST yields trended lower, but the USD/JPY shot higher on 29 August amid a lack of any notable catalysts, rising to 147.37 – the highest level since November 2022. However, the Job Openings and Labor Turnover Survey (JOLTS) for July and the consumer sentiment index released on the same day undershot market expectations. This sent the USD/JPY down to the upper 145 level, and although it subsequently rebounded, it became top-heavy around 146.5 and dropped back to around 145.5. It was trading around 146 at the time of writing this report (Figure 1).

Dollar has continued to strengthen since mid-July

The dollar strengthened across the board in August (Figure 2). In fact, the dollar has been trending stronger since mid-July, but this was due to a rise in US interest rates. Data such as the 0.7% MoM rise in US July retail sales announced on 15 August, which greatly beat market expectations, have changed perceptions of the US economy, and expectations of a recession in 2H have evaporated. As a result, expectations (concerns) that future interest rate cuts will be delayed have increased. A deterioration in UST supply/demand has also contributed. The US Treasury is proceeding with financing that was delayed due to the federal debt ceiling issue. It also plans to increase the issuance of USTs to keep the economy in good shape ahead of next year's presidential election. As a result, the 2y UST yield briefly rose to the 5.1% level and the 10y UST yield to above 4.35%, which has encouraged the dollar to strengthen.

FIGURE 1: USD/JPY (DAILY)

Note: As at 13:00 JST on 31 August

Source: EBS, MUFG

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

Note: As at 13:00 JST on 31 August

Source: Bloomberg, MUFG

Indecisive Fed stance

Fed Chair Powell's speech at Jackson Hole in August did not deviate from his post-FOMC press conference at the end of July. Over that period, it became apparent again that the Fed's aim to ease inflation by loosening tight labor supply/demand conditions through tighter monetary policy was not proceeding as planned, with the jobs report for July showing a decline in the unemployment rate and retail sales growth accelerating to 0.7% MoM (Figure 3). The Fed Chair's Jackson Hole speech is generally seen as an indicator of the direction of subsequent monetary policy. However, this time the event turned out to be underwhelming as Powell did not signal the need for further monetary tightening or declare victory in the fight against inflation to date.

Powell said, "we will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data," basically indicating that the Fed has little choice but to maintain its stance that future monetary policy decisions will depend solely on the data. He used the word "carefully" many times. The question is whether this implies that the Fed is planning to keep rates on hold at the next FOMC meeting on 19-20 September. In addition, the JOLTS report announced on 29 August after Jackson Hole showed a continued decline in job openings, and the August ADP employment report on the 30th showed a slowdown in payrolls growth. Neither result should spur the Fed to follow up on its July rate hike, meaning we would expect the FOMC to keep policy on hold at the September meeting. The FF interest rate futures market has priced in an almost 90% chance that the rate will be left unchanged. Chair Powell is also unlikely to be able to declare inflation has been vanquished at the meeting. We do not expect the Fed to abandon the option of hiking one more time and cutting off an exit route given the risk of inflation gathering pace again with the economy regaining its strength. Therefore, if the Fed keeps rates on hold as we expect, the dollar will not weaken.

However, we should also pay attention to the outlook for the federal funds rate (the dot plot) that will be updated at the September FOMC meeting. The median forecast in June was for a total rate cut of 100bp next year (Figure 4). Some senior Fed officials have said the timing of the start of rate cuts could be pushed back, meaning that the (outlook) for rate cuts over the year could be less than 100bp. In addition, a New York Fed research paper noted that the neutral interest rate, which keeps inflation constant, may be rising. This has drawn attention since it could signal a change in the Fed's longer run federal funds rate projections which are positioned as the neutral rate of interest. An upward revision could lead to speculation that monetary policy is not tight enough and increase the likelihood of cuts being pushed back. The outlook in this regard remains unclear because Powell has avoided commenting directly on this point, arguing that an accurate forecast is impossible. Naturally, the dot plot cannot be taken as set in stone having already been significantly revised several times since last year. However, the financial markets have little choice but to use it as a source of price formation since it does represent the Fed's thinking at the time. We therefore expect the dollar would strengthen again if the dot plot showed smaller rate cuts or a higher longer run rate.

The fact that Powell did not hint at an additional interest rate hike in September at the Jackson Hole symposium may have resulted in the dollar's strength (or the USD/JPY) peaking. In any case, with the Fed's stance still uncertain, we expect conditions will continue to fluctuate based on the data and statements made by senior Fed officials.

FIGURE 3: US RETAIL SALES GROWTH (MOM)

Source: Bureau of Labor Statistics, MUFG

FIGURE 4: FOMC PARTICIPANTS' MEDIAN FED FUNDS RATE OUTLOOK

Source: Fed, MUFG

Yen sellers still reassured, but a shift in monetary policy coming into view

On the other hand, the yen's nominal effective exchange rate, which had stopped declining in July, showed signs of moving lower again in August. The BOJ moved to increase the flexibility of yield curve control (YCC) at the end of July, but the yen continued to weaken. We think the BOJ's moves have effectively abolished YCC, but the BOJ's official position is that it is maintaining YCC and that this revision only increased its operational flexibility rather than being a shift to normalization. In addition, although increasing the flexibility of YCC allows long-term yields to rise above 0.50%, the BOJ conducted an extraordinary operation immediately after this which gave a sense that the "upper limit" was around 0.65% (yields subsequently rose to around 0.68%, Figure 5). For this reason, with the monthly trade balance improving by nearly ¥1trn compared to last year due to falling prices of fuel resources such as crude oil, LNG, and thermal coal, we thought pressure on the yen to weaken would decline if the BOJ revised its monetary policy. However, this did not change the theme of the disparity in domestic and foreign monetary policy and interest rate differentials, and yen sellers continued to feel a sense of security.

However, we think the normalization of monetary policy is coming into view. The opening paragraph in the BOJ's July board meeting statement on monetary policy said, "taking account of extremely high uncertainties for economic activity and prices, it is appropriate for the Bank to enhance the sustainability of monetary easing under the current framework by conducting yield curve control with greater flexibility and nimbly responding to both upside and downside risks to Japan's economic activity and prices." Before this, the "uncertainties" the BOJ referred to have a strong connotation of downside risks, but this time it purposefully added the phrase "both upside and downside risks." In other words, the BOJ is starting to pay more attention to upside risks, especially in terms of prices. This position is also reflected in Deputy Governor Shinichi Uchida's speech on 2 August. The BOJ has repeatedly revised up the outlook for prices in its Outlook report, which is reviewed quarterly. Regarding this, Deputy Governor Uchida said that "the effects of cost-push factors are lasting longer than expected and firms' wage- and price-setting behavior is changing somewhat earlier than anticipated" and "my assessment at this point is that signs of change have been seen in firms' wage- and price-setting behavior." Furthermore, on the topic of wages, which Governor Ueda and other board members are keening focused on, he suggested that it was not just a case of government flag-waving, but wage growth due to a structural labor shortage, noting that "my assessment is that the basic structure of the labor market will be unchanged next year and beyond" and "from the perspective of labor market conditions, the environment where wages are likely to increase will continue." In other words, the BOJ expects a sustained rise in wages, but it wants to confirm this just in case, with the main scenario likely to be a move toward the long-awaited normalization of monetary policy.

We therefore expect wage increases in FY24, especially the result of spring wage negotiations, to be key for monetary policy decisions and impact the direction of USD/JPY. Regarding this point, policy board member Naoki Tamura on 30 August said, "a large wage increase can be expected in next year's spring wage talks." In addition, the period to assess this should be from January through March 2024. Trends in FY24 wage increases should become clear to some extent, especially for large companies, as early as the end of the year. In that case, we expect the BOJ to start normalizing policy with the release of the Outlook report in January 2024.

We expect wage hikes in FY24 to be similar in scale to this year given the Kishida government's strong push to increase wages, curbs on import prices giving companies greater leeway to pay higher wages, and the structural labor shortage. We therefore expect the BOJ to at the least formally end YCC at the January monetary policy meeting and announce that it is normalizing policy. The BOJ could also move to swiftly end the negative interest rate policy if the inflation rate does not decline, contrary to its forecast (Figure 6). This would be a game changer for the foreign exchange markets and would likely reverse the phase of yen weakness that has persisted for the last couple of years. Conversely, we expect the risk of yen weakness to persist until then.

FIGURE 5: 10Y JGB YIELD

Source: Bloomberg, MUFG

FIGURE 6: JAPAN'S CPI GROWTH (YOY)

Source: MIC, MUFG

Waiting for the weak yen to plateau and a shift to dollar weakness?

We expect the strong dollar and weak yen environment to persist for now and see the need to be on the alert for USD/JPY upside risk. The USD/JPY is already at a high level, and some domestic retail traders are engaging in contrarian margin trading in which they sell the dollar and buy yen. However, because the substantial difference in domestic and overseas interest rates means they can make money through carry trades, we therefore do not expect the USD/JPY to trend lower unless the theme of the disparity between monetary policy changes in earnest. Naturally, the risk of the Japanese government intervening in the currency markets looms as a risk considering what happened last year. We expect this to act as a strong curb on yen depreciation and weigh on upside. In addition, the rise in US interest rates, which supported the strong dollar in August, has temporarily peaked out, and from the perspective of interest rate differentials, we see limited room for the dollar to strengthen and the yen to weaken. However, the Fed's policy remains data dependent, meaning the USD/JPY is likely to fluctuate based on the details of economic indicators and comments from senior Fed officials. In light of this, we see the possibility that the USD/JPY could move beyond 150 and beat last year's highs until it is clear that the Fed has finished raising rates.

However, we are also mindful of downside risks in the short term. In particular, high prices have become a key political issue in Japan due to the rise in gasoline prices, and this could impact the weak yen and monetary policy. Gasoline prices have been curbed by extending subsidies scheduled to end in September out to the end of the year, but at this rate the issue could come to the fore again toward year-end. The government is clearly aware of the problem, with Finance Minister Suzuki noting on 30 June that the weak yen was not desireble from the perspective of curbing the rise in prices. However, despite the decline in USD/JPY volatility and higher inflation than last year, the disparity in domestic and foreign monetary policy means it could be even more difficult than last year to seek understanding for intervention in the currency markets. We suspect this is why there have been fewer moves to check the yen's weakness than in the past, although tensions are not absent. However, we think it would be a different story if the USD/JPY moves beyond 150 and tests last year's high.

In addition, the BOJ is likely to face increased pressure to respond with monetary policy as such developments approach. The July policy revision lacked continuity with the discussion up to the previous meeting in June, and we think the BOJ may have faced external pressure in the form of a request to deal with the ongoing depreciation of the yen. Governor Ueda acknowledged that the revisions were made with foreign exchange market trends in mind. The BOJ may be forced to take measures that do not align with the logic it has established to date if the yen weakens rapidly. Even if that is not the case, the BOJ under Governor Ueda, which seems to be approaching this phase with a strategy of gradual normalization in order to avoid a sudden change in monetary policy, may soon be ready to remove the BOJ's overshooting commitment in which it pledges to "continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds 2% and stays above the target in a stable manner" given the conditions for this have already been achieved.

QUARTERLY FORECAST RANGE AND PERIOD-END FORECAST

	Sep 2023	Oct-Dec	Jan-Mar 2024	Apr-June
USD/JPY	140.0～151.0	138.0～152.0	132.0～148.0	130.0～146.0
Period-end forecast	145.0	145.0	138.0	136.0

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.