Will Fed rate cuts really be negative for USD/JPY? Via Investing.com

Investing.com — The potential impact of the US Federal Reserve’s interest rate cuts on the pair is a critical issue for currency investors and strategists, especially as we approach a possible Fed pivot in 2024.

Given the diverging monetary policies between the Fed and the Bank of Japan (BoJ), market participants are divided on whether the Fed’s rate cut will lead to USD/JPY weakening.

According to analysts at BofA, the relationship between Fed rate cuts and USD/JPY is more nuanced, with a variety of structural and macroeconomic factors playing a role.

Contrary to common market expectations, the relationship between Fed rate cuts and a weakening USD/JPY is not a given.

Historically, USD/JPY has not always declined during Fed easing cycles. The key exception was during the Global Financial Crisis (GFC) of 2007-2008, when the unwinding of the yen trade led to a significant appreciation of the yen.

Outside of the GFC, Fed rate cuts such as those seen in the 1995-1996 and 2001-2003 cycles did not lead to a major decline in USD/JPY.

This suggests that the broader economic context, particularly in the US, plays a crucial role in how USD/JPY reacts to Fed rate moves.

BofA analysts point to a shift in capital flows from Japan dampening the likelihood of a strong JPY appreciation in response to Fed rate cuts.

Japan’s foreign asset holdings 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 fall, Japanese investors are unlikely to repatriate funds en masse, limiting upward pressure on the yen.

In addition, Japan’s demographic challenges have contributed to persistent FDI outflows, which have proven largely insensitive to US interest rates or exchange rates.

This ongoing capital outflow is structurally bearish for the yen. Retail investors in Japan have also increased their exposure to foreign shares through investment trusts (Toshins), and this trend is supported by the expanded Nippon Individual Savings Account (NISA) scheme, which encourages long-term investments, rather than short-term speculative flows.

“Without a hard landing in the US economy, Fed rate cuts may not be fundamentally positive for the JPY,” analysts said.

The risk of a prolonged US balance sheet recession remains limited, with the US economy expected to get a soft landing.

In such a scenario, USD/JPY is likely to remain elevated, especially as Fed rate cuts are likely to be gradual and moderate based on current forecasts.

Expectations of three cuts of 25 basis points by the end of 2024, rather than the more than 100 basis points the market is pricing in, further support the view that USD/JPY could remain strong despite the easing of monetary policy by US.

Japanese life insurers (lifers), which have historically been major participants in foreign bond markets, are another key factor to consider.

While the high cost of hedging and the outlook for a weaker yen have prompted lifers to reduce their hedging rates, this trend limits the JPY’s upside potential in the event of a Fed rate cut.

In addition, lifers have reduced their exposure to foreign bonds, with public pension funds leading much of Japan’s foreign bond investments.

These pension funds are less likely to react to short-term market fluctuations, further reducing the likelihood of an appreciation of the yen.

While BofA remains constructive on USD/JPY, certain risks could change the trajectory. A US recession would likely lead to a more aggressive series of Fed rate cuts, potentially pushing USD/JPY to 135 or below.

However, this would require a significant deterioration in US economic data, which is not the base case for most analysts. Conversely, if the US economy re-accelerates and inflationary pressures persist, USD/JPY could rise further, potentially retesting 160 in 2025.

The risk from BoJ policy changes is considered less significant. 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 exert more influence on USD/JPY than BoJ moves.

Additionally, the Japanese economy is more sensitive to changes in the US economy than the other way around, which reinforces the idea that Fed policy will be the dominant driver of USD/JPY.