The Japanese yen has been steadily depreciating since the beginning of the year, thanks in part to the delayed prospect of rate cuts by the US Federal Reserve and the strength of the US economy.
Goldman Sachs Research expects the yen to remain at or above 150 to the dollar over a 12-month horizon. In late April, the yen hit 157.8 to the dollar, a level not seen since 1990. On April 29 and May 2, Japan’s finance ministry made two apparent interventions in the foreign exchange markets, selling dollars to shore up its currency.
We spoke to Goldman Sachs Research economist Tomohiro Ota and senior currency strategist Michael Cahill about the yen’s slide and its implications for Japanese central banking policy and its economy.
What has driven the decline of the yen this year?
Cahill: First and foremost, it’s the macro environment that is weighing on the yen. The yen tends to appreciate when recession risk is high — when yields are lower, and people are worried about growth. But we’ve had the opposite of that recently. We’ve seen surprisingly resilient growth, especially in the US, which has come despite the Fed keeping its rates high. Instead of having high recession risk, we’re tracking US growth at around 3% despite high yields. That combination is weighing on the yen.
Ota: Apart from those big structural factors, there was also a short-term event that may have triggered additional depreciation in the last couple of weeks. After the Bank of Japan held its monetary policy meeting in April, it sent two signals: one, that it does not react directly to the FX markets, and two, that its primary policy target is sustainable inflation. To the BOJ, the dollar-yen rate matters only when currency fluctuations have some impact on reaching their target.
What about individual Japanese people investing in foreign securities?
Cahill: It’s hard to gauge the impact of this on foreign exchange. One thing we can say, with a longer-term perspective on yen depreciation, is that in US dollar terms, it has been much more attractive for Japan-based investors to invest abroad, on an unhedged basis, than for foreign investors to invest in Japan on an unhedged basis. Part of what makes it attractive is that, even though yen yields have risen, they’ve been very low compared to the rise in other markets, especially the US. That’s a big reason why the yen has been more responsive to US yields in particular.
Ota: Another aspect of cross-border cash flows is that we’ve had an extension of a tax benefit for retail investors, in a scheme that allows investment in securities. Through it, many retail investors reportedly decided to invest in foreign equities more than before, which creates a net outflow to other markets, although it is difficult to know exactly how much this affects the yen.
Is there a line in the sand for the BOJ — a threshold for yen depreciation that policymakers will defend?
Cahill: We’ve found out that the authorities are much more sensitive to the pace of depreciation and to disjointed moves that are out of line with other market fundamentals. That is also what matters economically. I’d be surprised if they have a long-term target of any kind.
In March, the BOJ ended its negative interest rate policy, raising borrowing costs for the first time since 2007. It also removed the cap on 10-year Japanese government bonds. How has that filtered through the FX market since? And how has that policy shift filtered through Japan’s economy?
Ota: The consensus view is that there has been no significant impact on the Japanese economy. The rate hike was only 10 basis points, which was a minimal increase. And in its March meeting, the BOJ announced that they will continue buying the same volume of Japanese government bonds every month, so it didn’t signal a move to quantitative tightening. They maintained that stance after their April meeting as well.
Cahill: And on the FX side — FX is a relative game. Even as we had a rate increase in Japan, we’ve also been pricing out rate cuts around the world. In the US, for example, we’ve moved to pricing in only two rate cuts this year. In effect, that has made it so that the BOJ’s movements barely register. The other important thing is that they described their rate hike as exiting their extraordinary easing policies, not as the launch of a big tightening campaign.
When might the BOJ raise interest rates again?
Ota: The market consensus now is that the BOJ will raise its policy rate again in September or October. Some economists expect a July hike, but in the most recent survey, the consensus lies with September or October. We expect the next hike to come in October.
What is your take on the BOJ’s terminal rate? What’s a simple way of understanding that idea, and why is it important for investors?
Ota: Japan is now at a crossroads. We’ve been in a deflationary environment for more than two decades, but the BOJ is now saying that sustainable inflation is their base case scenario. We also think that the Japanese economy has a good chance of getting out of the so-called deflation trap. In that case, near-zero interest rates are not justifiable. The terminal rate is where the policy rate is expected to peak during the business cycle. Right now, the consensus is that Japan’s policy rate will peak around 0.75%. But we think it could go as high as 1.5%. If households and firms become convinced that higher inflation is here to stay, that will change pricing and spending behaviour. In turn, the BOJ should be able to raise the policy rate further without restricting the economy too much. This matters for investors trying to gauge how the market (and the economy) will respond to rate hikes.
How might the BOJ react to further yen weakness — or will it?
Ota: Although we expect the next rate hike to come in October, there is a low bar for it to come somewhat earlier. That’s because the next hike is expected to be another relatively small one — 15 basis points this time. But we do not expect the BOJ to cite yen weakness as the primary reason for raising the policy rate.
Cahill: If the yen weakens enough to impact the inflation outlook, that could in principle lead to faster rate hikes from the BOJ. In fact, the BOJ has said that exchange rate fluctuations might have a bigger impact on price-setting behaviour right now. But keep in mind that a modestly weaker yen would help the BOJ reach its inflation target. And, importantly, Japan has more targeted tools to deal with exchange rate volatility that looks out of step with fundamentals. With about $1 trillion in foreign exchange reserves, Japan is one of the largest reserve managers in the world. So the ministry of finance has plenty of capacity to intervene in the FX market if it needs to. But there are limits on how effectively authorities can manage the exchange rate without taking more decisive action that could have unwelcome side effects.
What is Goldman Sachs Research’s outlook for GDP growth in the coming 12 months, and how has that shifted since the start of the year?
Ota: Currently our GDP growth forecast for the calendar year 2024 is 0.5%. This is lower than our initial forecast in November last year of 1.5%. The main reason for that downgrade is a temporary drop in consumption in the January-March period, reflecting the fact that some Japanese automobile companies had to close their production lines because of problems with the quality assurance process. But that is a temporary issue and doesn’t change our macro narrative. Following this brief setback, we expect positive growth for the rest of the year, including a temporary consumption boost from an income tax cut over the summer.
What is your outlook for the yen over the next six and 12 months, and why?
Cahill: We expect the yen to remain around current weak levels over the next 6-12 months. The bottom line is that the macro environment should continue to weigh on this safe-haven currency, and the Fed cuts (and BOJ hikes) that we expect probably won’t provide that much support. We think recession risk remains fairly low, and there is not much room for 10-year US yields to rally, which is what would typically strengthen the yen. The yen could weaken further if the US economy proves even more resilient than we expect, and if the Fed delivers even fewer rate cuts down the line.
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