Resurgent US Dollar, Weak Japanese Inflation Push Yen Near New Lows

Following reports of the Bank of Japan's intervention in early May, the Japanese yen experienced a short-term rebound, only to weaken again recently, approaching historical lows against the US dollar, with the USD/JPY pair seemingly heading towards the 160 mark once more.

As of last week's close, the USD/JPY was reported at 157.01. In early May, under intervention, it had come close to 150, but with the strengthening of the US dollar, the continuous cooling of expectations for a Federal Reserve rate cut, and the decline in Japan's inflation data, the yen has started to plummet again. Japan's April CPI slowed down from 2.7% in March to 2.5% year-on-year, and the core inflation rate, excluding fresh food prices, was even weaker, dropping from 2.6% to 2.2%.

It is worth noting that on May 24th, the Chinese yuan's midpoint rate broke through 7.11, reaching a new low in over four months. As previously reported by First Financial Daily, due to the yuan becoming a low-interest currency, the correlation between the yuan and the yen has significantly increased in recent years. With the recent resurgence of the strong US dollar, the offshore yuan has once again fallen close to 7.26. In the future, in addition to monitoring Federal Reserve policies, the yen's trend may also provide clues for the yuan's trajectory.

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The yen exchange rate is approaching 160 again.

Japanese inflation is not developing in the direction the Bank of Japan desires. The prospect of a sustained increase in Japanese inflationary pressure seems to be gradually fading, unless employers significantly raise wages to boost overall demand. However, analysts generally believe that, based on the current trajectory of price pressures, it is difficult to see a virtuous cycle between wage increases and inflation continuing in the short term, which has been the main factor supporting the yen's appreciation expectations since last year. Currently, both overall and item-specific price pressures are experiencing a severe disinflationary phase, casting doubt on the Bank of Japan's ability to further raise interest rates beyond the one increase already implemented.

Matt Weller, Global Head of Research at Gain Capital Group, told reporters that although Japan's core data for April met expectations and was still above the Bank of Japan's 2% target, it was a full two percentage points lower than the high point touched at the beginning of 2023. The CPI excluding energy and food is also the case, having slowed down significantly over the past year, from 2.9% in March to 2.4%.

"With the Japanese economy contracting in the first three months of this year, the hope for a continued rise in inflation mainly relies on the household sector, where positive real wage growth would provide a favorable factor for weak household spending. If this hope is dashed, it is hard to see the Bank of Japan raising interest rates further. Even with a weaker yen, there is little indication from upstream price indicators that consumer prices are generally rising," Weller said.

This is a problem for the Bank of Japan and the market because the Bank of Japan expects to raise interest rates by about 15 basis points next year. Due to strong US economic data, bets on a Federal Reserve rate cut this year have been reduced to below 30 basis points, and the yield differential between the two countries remains at a historical high, prompting traders to continue buying on dips.

Against this backdrop, the USD/JPY has once again approached the 160 mark. In fact, as early as April, the yen experienced a significant devaluation, and now it seems that bears are making a comeback. The week of April 29th witnessed huge fluctuations in the yen - at that time, the Bank of Japan's meeting statement was less hawkish than expected, and yen bears continued to wreak havoc, with the USD/JPY surging 2.3% and breaking through 158. On the morning of April 29th, it briefly touched 160, the highest level since April 1990, before plunging back to around 156.

Several traders told reporters that the Bank of Japan has no intention of reversing the yen's trend, but merely does not want to see the yen depreciate too quickly in the short term, which also provides clues for future intervention conditions.There is a viewpoint that suggests the Bank of Japan's accounts may decrease by 7.56 trillion yen ($48.2 billion) in early May. This is significantly more than the expected decline of about 2.1 trillion yen, indicating that the Bank of Japan intervened by approximately 5.5 trillion yen.

"After the suspected intervention by the Bank of Japan, the US dollar/Japanese yen pair once fell below 152, but then began to steadily climb over the following two weeks. This was not due to any action by the Bank of Japan, but rather because the Federal Reserve's rate cut expectations kept being postponed, leading to the US-Japan interest rate differential remaining at a relatively high level. For bulls, 158 is the next target, and after capturing it, they will once again challenge the 160 level," said Weller.

Rate cut expectations plummet, making it difficult for the US dollar to weaken.

A major cause for the weakening of the yen is the change in expectations for US rate cuts. In fact, rate cut expectations have been fluctuating throughout the year, but the current consensus is that US inflation is unlikely to decline completely, and the Federal Reserve, which is determined to combat inflation, is more likely to postpone rate cuts to ensure that inflation does not rise again.

As of last Thursday, the US dollar index rebounded for three consecutive days, approaching the 105 level. The Federal Reserve meeting minutes released that day once again pointed out that the pace of inflation decline is slower than expected, and the policy rate needs to be maintained at the current level for a longer period. At the same time, some participants expressed a willingness to further tighten. The rate market's bets on rate cuts have noticeably retreated compared to last week.

The minutes exceeded market expectations. The US dollar warmed up, and the commodity boom temporarily cooled down. Gold fell nearly 2% overnight, while silver fell nearly 4%, and copper prices plummeted by 5%. At the same time, non-US currencies also generally declined, including the yen and the renminbi.

Due to the easing of employment demand and layoffs, the number of initial jobless claims in the US for the week ending May 18 continued to decline, falling by 8,000 people compared to the previous value, marking the largest consecutive decrease since September last year. Currently, traders are more focused on the upcoming PCE price index, which is also the data more favored by the Federal Reserve.

More institutions are beginning to believe that a single decline in April CPI is not sufficient to support the decision to cut rates. The Federal Reserve will need to receive 2-3 months of satisfactory data before considering action. As a result, more institutions expect the first rate cut to appear in September, not June, and the forecast for the number of rate cuts has also been reduced to one cut within the year.

UBS Global Chief Economist Arend Kapteyn recently said to reporters that the Federal Reserve focuses on PCE inflation, and rent accounts for a large proportion of this index, which cannot be simply ignored. The institution believes that considering the cooling of the overheated segments of the labor market, and a slight increase in the unemployment rate may help to eliminate the remaining inflation stickiness, which moves the US economy towards a "soft" landing. By the fall, the Federal Reserve should be able to see enough evidence of economic slowdown and improvement in inflation to support rate cuts.

However, in his view, risks include the economy not slowing down or core inflation remaining closer to 3%. In addition, a further decrease in the unemployment rate may also become an obstacle to rate cuts. UBS believes that this scenario will sound the alarm and may lead the Federal Reserve to restart rate hikes at some point in 2025. This would result in the economy "not landing." The latter is not the base forecast, but it is not impossible to happen.The Chinese Yuan Follows the Japanese Yen in Weakening

Recently, the Chinese Yuan has once again experienced a decline. Industry insiders believe that it is necessary to pay attention to the correlation between the Japanese Yen and the Chinese Yuan. On May 24th, the midpoint rate of the Yuan was reported at 7.1102, setting a new low for over four months. Liu Yang, a foreign exchange expert and General Manager of the Financial Market Business Department of Zhejiang Zhongshang Group, said to the reporter: "On May 23rd, the midpoint rate was 7.1098, and the offshore Yuan approached the upper limit of the fluctuation range. In the future, it is necessary to continue to pay attention to the possibility of the Yuan's continuous small displacement, but excessive fluctuations may still be unwelcome. At present, the People's Bank of China's willingness to maintain exchange rate stability remains strong."

Liu Yang stated that the correlation between the Yuan and the Japanese Yen's exchange rates is increasingly being noticed by institutions. Currently, the US Dollar is a high-interest currency, while the Yuan is a low-interest currency, making the latter increasingly a financing currency for enterprises, that is, borrowing in Yuan and investing in other high-interest currency assets such as the US Dollar. "In the onshore market's proprietary carry trade, the Yuan is already a financing currency, and the underlying logic of research and trading has changed."

The Japanese Yen has implemented a low-interest-rate policy for many years and has become an established financing currency. In carry trades, investors borrow in Yen and then invest in US Dollar assets, among others. "The long-term downward trend of the Yuan's interest rate seems to have formed some market consensus, and foreign capital is more sensitive to this change. This is also why the trend of the Yuan's exchange rate has been highly similar to that of the Japanese Yen in the past two years," Liu Yang said.

In the future, it is expected that the People's Bank of China will ensure ample liquidity, may lower the reserve requirement ratio again, and use other liquidity tools such as the Medium-term Lending Facility (MLF). UBS also stated that if the combined effect of existing policies is still insufficient, the government may introduce more measures.