Yen's Global Surge: Ceiling Potential & US-Japan Yield Gap Impact
The financial landscape has seen dramatic fluctuations recently, particularly in the relationship between the Japanese yen and the US dollar. In just a month, the yen appreciated by a staggering 10%, largely due to unexpected hawkish signals from the Bank of Japan. This shift has sent ripples across global markets, with the low-yielding yen facing significant liquidation from carry trades against higher-yielding currencies.
As of August 5 at 5:30 PM Beijing time, the USD/JPY exchange rate stood at 141.94, having previously soared to a historic high of 162.01 in July. The repercussions were swift; by August 5, the Nikkei 225 Index plummeted nearly 13%, a drop not seen in a long time. Since its peak this year, the index has shed about 10,000 points. However, by August 7, the dollar-yen exchange rate stabilized around 145, leading to a remarkable rebound in the Nikkei 225, which opened with an 11% gain, closing at 34,675 points. The critical question now on everyone's mind is: how much more can the yen rise? This alteration directly influences the trajectory of the Japanese stock market and shapes global market sentiment.
When the yen weakens, the Japanese stock market often sees a rebound. In the short term, technical analysis remains a focal point for traders. David Scutt, a senior strategist at Stonex, pointed out that the currency pair had recently breached resistance levels established in early 2023. He referred to the significant support levels at 140.25 and the 2021 trend line intersecting around 137.7. Should these supports fail, it would signal escalating fears of a hard landing and increased bets on Federal Reserve rate cuts.
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Encouragingly, the yen saw a pullback after its previous rally. By August 6 at 3:00 PM Beijing time, the USD/JPY stood at 145.5245. Following this depreciation of the yen, the Nikkei index benefitted significantly, closing sharply higher at 34,675 points, rebounding from the previous day's low of 31,458 points. Scutt noted that after Monday's sharp decline, there was substantial price recovery, pushing the market back to prior support levels, which might now act as resistance: 35,280 and 35,700, as well as trends established earlier this year. The short-term outlook for the Nikkei may hinge on further upward movement in the USD/JPY exchange rate to break through these critical areas.
In a parallel development, the US ISM Services Index unexpectedly rose to 51.1, surpassing the anticipated 46.4 and the previous figure of 46.1. This positive data alleviated market concerns about a looming recession. Furthermore, the new orders and employment indexes within the ISM Services report indicated expansion, which likely contributed to stabilizing the dollar against the yen.
In the midst of the recent turmoil, Manulife Investment Management indicated that the financial sector—including banking, insurance, and brokerage—was hit hardest by the downturn. Other sectors like trading companies and automotive also felt the strain. However, defensive sectors and industries geared towards domestic markets, including retail, healthcare, railroads, and telecommunications, experienced comparatively smaller declines. Interestingly, although the financial industry has no direct exposure to the yen, the market's altered expectations surrounding interest rates due to recent volatility had far-reaching implications. The expected yield on ten-year government bonds dropped from over 1% to below 0.8%, significantly diminishing prospects for a Bank of Japan rate hike by the end of 2024, which tumbled from a 50% likelihood to nearly zero. This shift altered investor sentiment towards financial stocks, while the decline in import prices due to yen appreciation could gently uplift the stock prices of domestically focused companies.
According to their analysis, the current price-to-earnings ratio in the Japanese market is around 12 times, which they deem relatively reasonable. Forecasting a dollar-yen exchange rate averaging 140, they predict steady profits over the next two years. Meanwhile, US markets show a considerably higher P/E ratio of around 22 times. The Japanese market is also buoyed by solid dividend yields and corporate buyback commitments, with expected total shareholder returns exceeding 5% over the next two years. Despite the potential impacts of unwinding carry trades, historically, severe market selloffs tend to be short-lived and volatile. The ongoing transition from deflation to inflation in Japan is expected to enable companies with pricing power to consistently raise prices, thereby fostering a sustained re-evaluation of the Japanese stock market.
Furthermore, the trajectory of US and Japanese treasury yields will provide crucial insights for investors moving forward. Before the recent downturn of global stocks and the USD/JPY pair, interest rate differentials had already begun to signal a potential shift in market direction. The two-year treasury yield differential between the US and Japan has been the most telling indicator, often corresponding to the fluctuations in USD/JPY over the past month. This differential has been shrinking since May, contrary to the strengthening of the dollar-yen pair, potentially foreshadowing a critical turning point in the market dynamics.
Masamichi Adachi, Chief Economist for Japan at UBS Investment Bank, reflected on the Bank of Japan's unexpected hawkish stance last week, which exceeded market expectations. He anticipates an interest rate hike to 0.5% in October. However, he expects the bank will maintain its posture in December and January of next year to ensure that wage negotiations in Spring 2025 yield significant salary increases. Following this, Adachi projects an increase to 0.75% by March of next year and 1.0% by June.
Currently, scrutiny of global investment positions is vital. The Commodity Futures Trading Commission's (CFTC) Commitments of Traders (COT) report indicates notable trends in yen positions within the US futures market. The latest COT report reveals a clear trend of short-covering in the yen, with a significant upswing of nearly 12% over the past three weeks generating speculation among traders that there could have been a fundamental low point for the yen, or a peak for the dollar-yen exchange rate. The report also shows that major speculative entities had increased their net short positions to a 17-year high, coming close to a historical maximum. However, by the last week, these positions had been reduced by about 60%, illustrating a shift in sentiment.
The report noted that short covering was a significant reason for this shift, but there has also been a steady increase in bullish bets lately. With the yen spiking an additional 6% between Wednesday and Friday last week, speculators are nearing a net long position.
Beyond Japan, the stance of the Federal Reserve is equally crucial as it will directly drive the direction of the USD/JPY currency pair. Currently, a rate cut seems almost inevitable, it’s merely a matter of how aggressively this will be applied. The non-farm payroll data from the US for July, released on August 2, reported a surprising rise in the unemployment rate to 4.3%, against a forecasted 4.1%, marking the highest level in three years. This sparked predictions of recession, and Goldman Sachs even mentioned that continuous underwhelming employment data could prompt the Fed to make an emergency 50bp cut in September. Additionally, the ISM manufacturing report also indicated contraction at the fastest pace in eight months, while yields on 10-year US treasuries fell below 4%, currently nestled in the 3.6% range.
Gary Dugan, CEO of The Global CIO Office, stressed the importance of recognizing that due to the currently high interest rates, the Federal Reserve has considerable maneuvering room with an adjusted real interest rate around +250 basis points. This setting may compel the Fed to implement a dramatic 50bp cut at its next meeting, with markets estimating a 67% chance of such an outcome.
In light of these developments, it is not hard to foresee that, after a relatively stable second quarter, market volatility may persist for some time. Recent data indicated an increase of $6.3 billion in net long positions on dollar futures. However, following the disappointing non-farm data, the dollar dropped by 1% last Friday amid recession fears. Nevertheless, should we be on a path towards an economic downturn, the dollar will inevitably revert to its role as a safe haven currency, regardless of how many rate cuts the Fed executes.