CIO Update: The yen’s weakness – what you should know

The Japanese yen has now weakened past 160 per US dollar, hitting its lowest levels in almost four decades. The currency’s depreciation – with the yen shedding over 2% in June alone and 14% year-to-date – has put it in the spotlight of global financial markets.

However, there is a case to be made for both the yen weakening and strengthening over the next 6 to 12 months. And even while fluctuations in the yen may result in near-term market volatility, our longer-term view on Japanese equities – based on structural factors – remains unchanged. Here’s a closer look.

Key takeaways

• The Japanese yen has reached its lowest level against the US dollar in almost 40 years. Its depreciation trend over the past few years has primarily been driven by the spread between interest rates in the US and Japan.

• However, market expectations generally point to a gradual yen appreciation in the months ahead, or to about 150-156 per USD by the end of 2024.

• Future yen movements will depend on economic data and policy responses from both the Fed and the BOJ. If inflation in the US stays sticky, that may mean rates stay higher for longer, prolonging pressure on the yen. Still, the potential for Fed rate cuts and BOJ hikes by year-end could temper that somewhat.

• Despite potential short-term volatility, our medium-term outlook for Japanese equities remains optimistic, based on structural changes in Japan's economic and market landscape. 

What’s been moving the yen?

The yen has been on a depreciating trend since March 2022, when the Federal Reserve started to aggressively hike interest rates.

The Bank of Japan (BOJ), on the other hand, has maintained a more dovish stance, resulting in a wide gap between US and Japanese rates (more on that in our August 2023 CIO Insights). This differential in interest rates has been the main driver of yen weakness.

What’s the direction of the yen going forward?

What happens next will depend on how the economic data evolve, and how policy makers react. 

• In the US, sticky inflation could keep interest rates higher for longer, keeping the US-Japan rate gap wide and prolonging pressure on the yen. That said, markets are pricing in 1 to 2 rate cuts from the Fed by year-end, which should help to narrow the rate differential.

• In Japan, continued policy normalisation away from looser monetary policy – including interest rate hikes and reduced bond purchases – should also help to narrow the rate differential and support the yen. Markets are pricing in 2 rate hikes from the BOJ by year-end, including one as soon as July.

We should note that Japan’s Ministry of Finance may also intervene to stem yen weakness. While it's done that a few times over the past few years, providing temporary relief from depreciation, the impact has tended to be short-lived.

Market participants also play a role in the direction of the yen. On balance, it appears that markets still see the yen on a slight appreciation path over the next 6 to 12 months.

• FX forwards. Currency forward markets, which reflect expectations of future exchange rates, are pricing in a stronger yen, at 156 per USD by year-end.

• FX options. Traders in the options markets are betting on the yen trading in the 150-165 range against the USD over the next 12 months.

• Economist forecasts. The consensus among economists points to a stronger yen. The median forecast sees the yen at 150 per USD by the end of 2024.

How can yen movements impact equities?

In general, a weaker yen has tended to coincide with stronger Japanese company earnings, particularly for export-oriented firms.

That’s because a weaker yen supports the nominal value of Japanese export sales. Assuming most of their costs are denominated in yen, then that’s also positive for their profit margins. Conversely, a stronger yen has the opposite effect, and is less supportive of equities.

And it’s important to note that a large share of Japan’s biggest listed firms are export-oriented. The industrials (think Mitsubishi or Hitachi) and consumer discretionary (like Toyota or Sony) sectors account for more than 40% of the TOPIX.

What are the implications for your portfolios?

Currency fluctuations can contribute to some near-term volatility in Japanese equity markets. While we will continue to monitor the impact on your portfolios, our medium-term outlook remains optimistic.

This view is grounded in significant structural changes taking place in Japan's economic and market landscape, including improved corporate governance, ongoing economic reforms, and recent legislation encouraging domestic investment.

Corporate governance reforms, for example, have resulted in a steady increase in stock buybacks and dividend payments over the past decade. And recent efforts from the Tokyo Stock Exchange to further improve capital efficiency and return on equity have been a key driver in renewed investor interest in the asset class, supporting Japanese equity prices.

We covered in detail these tailwinds in our 2024 H1 Macro Outlook.

Looking ahead, risks to the yen could go both ways

As we look ahead, it's important to recognise that the yen's trajectory is influenced by a complex interplay of factors, each capable of pushing the currency in either direction. Here are a few of the risks that StashAway’s investment team is monitoring:

Weaker yen:

• In the absence of a trigger for a reversal, current market momentum could create a self-fulfilling cycle, where expectations of yen weakness lead to further depreciation.

Stronger yen:

• The yen's reputation as a safe-haven currency means that any significant global economic shocks could trigger a flight to safety, potentially driving up its value.
• If former President Donald Trump wins the US election in November, that could lead to pressure on Japan to strengthen the yen, reminiscent of the 1985 Plaza Accord.

While it's prudent to stay informed about market dynamics like the yen’s ongoing depreciation, it shouldn't overshadow the importance of maintaining a long-term investment perspective.

Making decisions based on short-term market volatility often leads to poorer outcomes. It’s better instead to focus on the broader economic picture and the long-term potential of the markets you’re investing in. Stay informed, but keep your eyes on the horizon.