Investing.com — The potential impact of US Federal Reserve rate cuts on the pair is a critical issue for investors and currency strategists, especially as we approach a possible Fed turnaround in 2024.
The divergent monetary policies between the Fed and the Bank of Japan (BoJ) have left market participants divided on whether Fed rate cuts will lead to a weaker USD/JPY.
According to analysts at BofA, the relationship between Fed rate cuts and the USD/JPY is more nuanced, with a variety of structural and macroeconomic factors at play.
Contrary to general market expectations, the relationship between Fed rate cuts and a weakening of the USD/JPY is not self-evident.
Historically, USD/JPY has not always fallen during Fed easing cycles. The main exception occurred during the 2007-2008 Global Financial Crisis (GFC), when the unwinding of carry trading in the yen caused a significant appreciation of the yen.
Outside of the global financial crisis, Fed rate cuts, such as those during the 1995-1996 and 2001-2003 cycles, did not lead to a major drop in USD/JPY.
This suggests that the context of the broader economy, especially in the US, plays a crucial role in how the USD/JPY responds to Fed rate moves.
BofA analysts signal a shift in Japanese capital flows that reduces the likelihood of a sharp appreciation of the JPY in response to Fed rate cuts.
Japan’s holdings of foreign assets have shifted from foreign bonds to foreign direct investment and equities over the past decade.
Unlike bond investments, which are highly sensitive to interest rate differentials and the carry trade environment, foreign direct investments and equity investments are driven more by long-term growth prospects.
As a result, even if US yields fall, Japanese investors are unlikely to repatriate funds en masse, limiting upward pressure on the yen.
Furthermore, Japan’s demographic challenges have contributed to continued foreign direct investment, which has proven largely impervious to U.S. interest rates and exchange rates.
This continued capital outflow is structurally bearish for the yen. Retail investors in Japan have also increased their exposure to foreign equities through investment trusts (Toshins), and this trend is supported by the expanded Nippon Individual Savings Account (NISA) program, which encourages long-term investments rather than short-term speculative flows.
“Without a hard landing in the US economy, Fed rate cuts may not be fundamentally positive for the JPY,” the analysts said.
The risk of a prolonged balance sheet recession in the US remains limited, with the US economy expected to achieve a soft landing.
In such a scenario, USD/JPY is likely to remain high, especially as Fed rate cuts are likely to be gradual and moderate based on current forecasts.
The expectation of three 25 basis point cuts by the end of 2024, rather than the 100+ basis points priced in by the market, further supports the view that the USD/JPY could remain strong despite the easing of US monetary policy.
Japanese life insurers (lifers), which have historically been important participants in foreign bond markets, are another important factor to consider.
While the high cost of hedging and the bearish yen outlook have led life investors to lower their hedging ratios, this trend limits the potential for a JPY rally in the event of Fed rate cuts.
In addition, life investors have reduced their exposure to foreign bonds, with public pension funds accounting for a large portion of Japan’s foreign bond investments.
These pension funds are less likely to respond to short-term market fluctuations, further reducing the chance of an appreciation of the yen.
While BofA remains constructive on the USD/JPY, certain risks could change its trajectory. A US recession would likely lead to a more aggressive series of rate cuts by the Fed, potentially pushing 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, USD/JPY could rise further, with a possible retest of 160 in 2025.
The risk of policy changes by the BoJ is considered less significant. Although the BoJ is gradually normalizing its ultra-loose monetary policy, Japan’s neutral interest rate remains well below that of the US, meaning Fed policy is likely to have a greater impact on USD/JPY than the BoJ’s moves.
Furthermore, the Japanese economy is more sensitive to changes in the US economy than the other way around, reinforcing the idea that Fed policy will be the dominant driver of USD/JPY.
