Yen depreciation driven by widening of long-term interest rate differentials between Japan and US

On the 21 October, the yen weakened to nearly 152 to the dollar during US market hours before rebounding all the way to a 144 handle in response to intervention. On Monday the 24th in Tokyo, the yen ended the day in the vicinity of 150 to the dollar after chopping around in a wide range amid speculation about resumed intervention.

Masato Kanda, Japan’s top FX diplomat, has since refused to confirm or deny whether Japan intervened in USD/JPY. He did say, however, that to strengthen the yen, Japan must strengthen its economy. Specifically, he mentioned the need for productivity-boosting reforms, including increased labor mobility, and a more diversified energy mix to improve Japan’s recently deteriorating balance of trade. While such reforms are indeed important, the issues they would address are not the reason the yen has recently been depreciating. As the yen has kept depreciating, some people have started to blame its weakness on factors other than rates, having seemingly grown weary of explaining that its depreciation is a function of Japan-US interest rate differentials. In actuality, however, there is no question that the yen’s ongoing depreciation has been driven primarily by widening of interest rate, particularly long-term rate, differentials between Japan and the US.

Yen previously strengthened excessively as Japan’s economic vitality waned

That Japan-US rate differentials are driving yen depreciation against the dollar is clearly evident from the fact that almost every country’s currency is in a downtrend against the dollar. There is no way that these countries are all weakening economically. Nor has the US economy been getting stronger.

Additionally, the Japanese economy’s potential growth rate and productivity growth rate, both of which are seen as proxies of economic strength, have been declining since the demise of its asset bubble of the late 1980s. Meanwhile, the yen has strengthened beyond 100 to the dollar on more than one occasion since the 1990s. After the 2008-09 GFC, the yen strengthened excessively, peaking below 80 to the dollar. No one believes these episodes of yen appreciation resulted from the Japanese economy getting stronger.

If a country’s productivity growth rate or potential growth rate declines, its consumer prices and wages tend to disinflate. Currencies of low-inflation countries should appreciate against currencies of countries with higher inflation rates according to purchasing power parity theory. In other words, countries that are losing economic vigor amid slowing productivity growth and/or a decline in their potential growth rates are most prone to currency appreciation. The belief that currency depreciation is a symptom of diminishing economic strength is a fallacy.

Deterioration in current account and trade balances have little impact on FX supply/demand balance

Given Japan’s dependence on energy imports, its current account and trade balances tend to deteriorate when energy prices rise. Such deterioration definitely leads to incremental selling of yen and buying of dollars (or other foreign currencies).

In 2021, Japan ran a current account surplus of ¥19.1tn. The IMF projected in its October World Economic Outlook that Japan’s 2022 current account surplus as a percentage of GDP will decrease by ~1.5ppt YoY. In yen terms, this decrease equates to some ¥8tn, nearly half of the 2021 current account surplus. Relative to the yen’s average daily trading volume of ¥54tn in the Tokyo market, however, an ¥8tn reduction in the annual current account surplus would not have an appreciable impact on the yen supply/demand balance in the FX market.

The yen has not been depreciating because Japan’s current account and trade balances have worsened in response to energy price inflation. Rather, it has been depreciating because the Fed has accelerated its rate hikes in response to energy price inflation.

Emergence of expectations of Fed step-down to 25bp rate hikes may halt yen depreciation

In sum, recent yen depreciation has been driven mainly by widening of long-term rate differentials between Japan and the US in the wake of a rise in US long-term rates in response to the Fed’s hawkish forward guidance. The rise in US long-term rates is likely to come to an end upon emergence of widespread speculation that the Fed will slow its rate-hiking cadence to 25bp per FOMC meeting. At that point, the yen should cease depreciating against the dollar. Such a step-down will likely occur sometime between year-end and March 2023. In the interim, I expect the yen to weaken further, with USD/JPY peaking south of 160.

Japanese authorities claim that their recent yen interventions were aimed at curbing excess exchange rate volatility, not halting the yen’s depreciation trend. The public, however, desperately wants the government to halt inflationary yen depreciation. By saying that a stronger yen is contingent on Japan strengthening its economy, Japanese currency authorities may be casting doubt on FX intervention’s effectiveness. The concern with such a message is that it could prove to be a self-fulfilling prophecy.

• Takahide Kiuchi

  Executive Economist