Is yen weakness coming to an end?

THE Japanese yen is one of the worst-performing currencies year to date. Having suffered from a year-long depreciation, the yen has weakened dramatically relative to the US dollar by around 26 per cent as at end-September, and against other major currencies. The yen’s weakness can largely be attributed to two factors.

First is a wide interest rate differential due to the policy divergence between Bank of Japan (BOJ) and other global central banks. While many central banks have expeditiously raised rates to combat inflation, the BOJ has retained its unyielding accommodative stance and kept rates low. Second is a widening trade deficit as a result of rising energy prices and the weaker yen. The large fall in export prices relative to import prices resulted in a trade shock (negative terms of trade), heaping depreciation pressure on the yen.

While these factors continue to weigh on the yen, we believe the currency weakness has hit an extreme level. Looking forward, we see limited downside for the yen relative to its upside and more reasons supporting the case for a stabilisation, and even a potential reversal beyond the near term. Four factors anchor our view.

• Policy divergence may continue, but the bulk of the divergence is likely over.

We believe a deteriorating growth outlook and cooling of inflation data will increasingly weigh on central banks’ hiking decisions. Already, key macro data are decelerating and negative surprises have become increasingly common. We see rising recession risk in 2023, making it progressively arduous for central banks to commit to their aggressive stance without risking a hard landing. While an outright dovish pivot from major central banks will take time, a pause on the hawkish rhetoric may suffice to break the market’s expectation on rising policy rates and reduce hawkish expectations, which in turn puts downward pressure on front-end yields.

This should slow or halt the widening in interest rate differential between major central banks and the BOJ, which we expect to remain accommodative, thus stabilising the yen. In particular, we think rising odds of a US recession should offer much relief to the yen, as much of the currency’s weakness against the US dollar can be attributed to aggressive Fed policy actions.

2. Rising possibility of further foreign-exchange intervention as macro implications deepen.

A weaker yen alongside rising commodity prices are hurting consumption and blowing up Japan’s trade deficit. With the macro environment worsening, political pressure to intervene and shore up the battered yen has also escalated, leading the BOJ to intervene for the first time since 1998 in late September.

We expect more intervention from the BOJ considering the worsening macro backdrop and continued verbal warnings from policymakers. Past interventions were often multiple attempts rather than a one-off effort. Beyond the direct support provided by FX intervention, its signalling effect will also be helpful in reducing depreciation pressure.

We believe it can deter further short selling, as traders are likely less inclined to bet on a weaker yen as the risk-reward becomes increasingly unfavourable after the intervention. Moreover, this signals that an intervention zone for US dollar/yen exists, likely above 145 to 146 yen, which may dampen the yen depreciation pressure beyond that threshold.

3. A potential pivot back to the yen as global recession fears rise.

The yen is traditionally a safe-haven currency, which tends to strengthen when the global outlook is uncertain or expected to deteriorate. However, given the yen’s poor performance, the currency has not been an effective safe-haven asset. Historically, the yen has strengthened against the US dollar and other trade partners during risk-off episodes, typically when equity markets see a major sell-off. However, this has yet to occur this year, during which global equities fell by 27 per cent (as at end-September) but the yen has depreciated against the US dollar and its trade partners.

Instead of conventional safe-haven currencies such as the yen, investors and traders have flocked to the US dollar, given the expeditious rise in Fed policy rates. That said, we believe a pivot back to the yen is possible – and likely – if a US recession occurs, which can slow the pace of Fed tightening, thus boosting the yen’s safe-haven appeal. This should help in reversing haven flows from the US dollar and back to the yen, especially if the exchange rate manages to stabilise.

4. Japan’s reopening and relative economic strength may offer support for the yen.

We expect a rosier growth outlook for Japan relative to developed market (DM) peers like US and Europe, underpinned by resilient consumption, accommodative monetary policy, and reopening tailwinds. This is in line with consensus forecasts, which expect Japan to deliver stronger gross domestic product growth among the DMs.

As Japan’s relative strength becomes increasingly prominent, enhancing the yen’s safe-haven appeal, we expect downward pressure on the yen to moderate. In addition, the easing of international border restrictions should also provide further relief through greater yen inflows from inbound tourism and investments, which we expect to pick up from Q4 2022 onwards.

Implications for Japanese equities

Historically, a weaker yen has proven supportive for Japanese equities. While this is largely true, extreme weakness in the currency can be undesirable when it amplifies macro headwinds like trade deficits, import costs, and consumer prices, which will in turn weigh on Japanese corporates. Furthermore, the FX loss from a weaker yen can erode any upside generated in local currency terms.

Therefore, we believe a stabilisation of the yen or even a rebound at such an extreme level is unlikely to hurt Japanese equities, especially if it alleviates these macro headwinds. Moreover, a stronger yen might also dispel the pessimism regarding Japanese equities and attract greater foreign inflows, which has been rather lacklustre this year. Lastly, any potential FX gains will enhance Japanese equity returns. Given our view, we prefer an unhedged approach to Japanese equities, maintaining exposure to the yen. We recommend the JPMorgan Funds - Japan Equity A (dist) SGD and iShares MSCI Japan ETF.

The writer is an assistant manager of the research and portfolio management team at FSMOne.com. FSMOne.com is the business-to-consumer (B2C) division of iFAST Financial Pte Ltd, the Singapore subsidiary of SGX-listed iFAST Corporation Ltd.