In the midst of a significant dollar surge, as interest rate differentials continue to favor the American currency, the Japanese yen has fallen to its lowest levels since November 2022. Japan’s Finance Minister, Shunichi Suzuki, maintains a laid-back stance on this shift, implying a hands-off approach by expressing that “currency rates should be determined by markets based on fundamentals”. Despite the calm exterior, Suzuki emphasizes his continued vigilance in monitoring the market trends.
The financial community is keenly interested in Suzuki’s comments concerning the yen because Japan has previously intervened in the forex market when exchange rates fluctuate too rapidly. A case in point is the Bank of Japan’s intervention in September 2022, which was their first such move since 1998. This was aimed at decelerating the yen’s drop in value, an action that successfully lifted the yen by 2% against the dollar.
The Bank of Japan (BOJ), as Japan’s central bank, is primarily tasked with formulating and executing monetary policies, managing foreign exchange reserves, and supervising financial institutions. As a central bank, its mandate is to maintain price stability, tweaking borrowing rates as necessary to control inflation. It also ensures the seamless flow of money between commercial banks within its jurisdiction.
The BOJ’s intervention is crucial for balancing the supply and demand for the yen, and, by extension, the functioning of domestic commerce. While a decline in exchange rate can make a country’s exports more globally competitive, it can also make imported goods more expensive, which could potentially pass the burden onto consumers and lead to inflation. The BOJ’s intervention last year temporarily achieved its aim as market players reacted by buying yen and selling dollars. The yen rebounded from nearly 150 to 130 per dollar within a five-month period.
The yen’s weakness has largely been attributed to the Federal Reserve’s swift hiking of interest rates, which has widened the gap between U.S. and Japanese short-term borrowing rates. The divergence in these interest rates moves in sync with the currency’s movement, as revealed by the changes in the U.S. two-year yield versus the two-year Japanese yield.
The interest rate differential is a key consideration in foreign exchange trading as it underpins the forex forward rate and contributes to forward points, which adjust the spot rate to account for the cost of carrying the currency till the forward date, and drives forex trading. A favorable interest rate differential implies earning interest on the owned currency. For instance, with the U.S. Fed Fund rate at 5% and the Japanese overnight rate at -0.10%, purchasing dollars and selling Japanese yen would yield a 5.1% annual return, assuming the spot rate remains unchanged.
The spot rate is the current exchange rate at which two currencies can be exchanged. It is the rate at which a currency can be bought or sold for immediate delivery. A spot currency rate delivers currency to a counterpart within two business days.
Fundamental analysis, which involves assessing the intrinsic value of a currency pair by examining related economic, financial, and other qualitative and quantitative factors, is used to understand currency movements. In the U.S., despite some data pointing towards a slowdown, most indicators show a strong economy. The U.S. Labor Department’s recent release of robust jobs data for May – 339,000, considerably above the expected 190,000 – boosted U.S. treasury yields, thereby tipping the interest rate differential in favor of the dollar.
Technical analysis also plays a key role in understanding currency movement. It involves studying past price actions and identifying patterns that may suggest future activities. A variety of tools are used for this purpose, including charts and moving averages, and indicators such as the MACD (Moving Average Convergence Divergence).
Currently, the USD/JPY is gaining momentum as U.S. yields rise relative to Japanese yields. The Japanese finance minister has signaled that the BOJ will refrain from intervening and let the markets determine the USD/JPY forex rates. However, the effects of a weak currency are a double-edged sword for Japan – while it could stimulate exports, it could also increase import costs, leading to higher inflation.
The U.S. Federal Reserve has increased interest rates by 5%, but the Fed Chair’s recent comments hinting at a possible pause has temporarily reduced the upward pressure on the USD/JPY. Despite this, market expectations still indicate further tightening by the Fed, with one more hike expected in July. Strong U.S. jobs data continues to drive yields at high levels, unlikely to decrease swiftly, thereby exerting continued upward pressure on the dollar. Technical indicators, too, suggest an ongoing upward trend for the dollar.