The potential impact of the US Fed Rate Cuts or Federal Reserve’s rate cuts on the USD/JPY pair is a critical issue for investors and currency strategists, particularly as we approach a possible Fed pivot in 2024.
With diverging monetary policies between the Fed and the Bank of Japan (BoJ), market participants are divided on whether the Fed’s rate cuts will lead to a weaker USD/JPY.
According to BofA analysts, the relationship between Fed rate cuts and USD/JPY is more nuanced, with various structural and macroeconomic factors at play.
Contrary to common market expectations, the link between Fed rate cuts and USD/JPY weakness is not a given.
Historically, USD/JPY has not always retreated during Fed easing cycles. The key exception was during the Global Financial Crisis (GFC) of 2007-2008, when the clearing of the yen carry trade caused a significant appreciation of the yen.
Outside of the GFC, Fed rate cuts, such as those seen during the 1995-1996 and 2001-2003 cycles, did not lead to a significant decline in USD/JPY.
This suggests that the context of the wider economy, particularly in the US, plays a key role in how USD/JPY reacts to Fed rate moves.
BofA analysts point to a shift in capital flows to Japan that dampens the possibility of a sharp JPY appreciation in response to the Fed’s rate cuts.
Japan’s 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 investment and equity investment are driven more by long-term growth prospects.
As a result, even if US interest rates are cut, Japanese investors are unlikely to repatriate capital en masse, limiting upward pressure on the yen.
In addition, Japan’s demographic challenges have contributed to the persistent outwardness of FDI, which has proven largely insensitive to US interest rates or exchange rates.
This continued capital outflow is structurally negative for gen. Private investors in Japan have also increased their exposure to foreign stocks through investment trusts (Toshins), and this trend is supported by the expanded Nippon Individual Savings Account (NISA) system, which encourages long-term investment rather than short-term speculative flows .
“Without a US economy hard landing, 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 elevated, especially as the Fed’s rate cuts will likely be gradual and modest, based on current forecasts.
The expectation of three cuts of 25 basis points by the end of 2024, rather than the 100+ basis points the market has priced in, further reinforces the view that USD/JPY could remain strong despite US monetary easing.
Japanese lifers, which have historically been major participants in foreign bond markets, are another key factor to consider.
While high hedging costs and a bearish outlook for the yen have led lifers to reduce hedge rates, this trend limits the potential for a JPY rally in the event of a Fed rate cut.
In addition, annuities have reduced their exposure to foreign bonds, with public pension funds making up the bulk of Japan’s overseas bond investments.
These pension funds are less likely to react to short-term market fluctuations, further reducing the chance of the yen appreciating.
While BofA remains bullish on USD/JPY, some risks could change course. A US recession would likely lead to a more aggressive series of Fed rate cuts, potentially pushing USD/JPY to 135 or lower.
However, this would require a significant deterioration in US economic data, which is not the baseline assumption for most analysts. Conversely, if the US economy accelerates again and inflationary pressures persist, USD/JPY could rise further, possibly revisiting 160 in 2025.
The risk from BoJ policy changes is seen as less important. Although the BoJ is gradually normalizing its ultra-loose monetary policy, Japan’s neutral rate remains well below that of the US, meaning Fed policy is likely to have more influence on USD/JPY than moves of the BoJ.
Additionally, the Japanese economy is more sensitive to changes in the US economy than the other way around, which reinforces the view that Fed policy will be the dominant driver of USD/JPY movement.
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Written by D Fernando
