USD/JPY Q1 2024 outlook

Evaluating the outlook for USD/JPY in 2024 need not be a complex task, merely requiring you to take a view on how interest rate differential between the United States and Japan may evolve, along with the risk we may see disorderly financial markets, leading to a repatriation of capital to Japan from abroad as carry trades are unwound. While neither are easy to predict, making it any more complex risks creating noise that could easily distract from the signals you should be paying attention to.

This report will look at where the Federal Reserve and Bank of Japan (BOJ) sit in their respective interest rate cycles, what is expected next year, where financial market pricing may be wrong, along with how the macro environment may influence the trajectory for risk appetite and asset valuations.

Where’s the Fed at?

After the one of the most aggressive tightening episodes in modern times, the Fed has signaled recently that interest rates have likely peaked for this cycle. It’s now talking about cutting rates three times in 2024, taking the funds rate target from 5.25-5.5% to 4.5%-4.75%. Markets are even more aggressive with their expectations, pricing in six cuts over the course of the year, the first tipped to arrive in March.

A lot of preemptive easing is now priced in with growth expected to remain positive, allowing inflation to glide back towards the Fed’s 2% target. It’s the definition of a soft economic landing, but as we’re all aware, reality does not always oblige. With the US jobs market incredibly tight and financial conditions moving rapidly towards expansionary territory, rather than the debate being whether the US will see a hard or soft-landing next year, the Fed’s unexpected early dovish pivot has arguably seen the risks shift to whether the US will see inflationary pressures accelerate again, resulting in a no landing scenario that may require tighter policy settings. While far from complete, the Atlanta Fed GDPNow model suggests momentum in the US economy is holding up in the fourth quarter after a strong performance in Q3.

_{Source: Atlanta Fed}

There’ll be more on the no landing risk later.

BOJ desperately seeking normality

In contrast to the Fed, the BOJ hasn’t managed to normalize monetary policy coming out of the pandemic, keeping its overnight policy rate unchanged at -0.1% and continuing to implement yield curve control (YCC), the process of artificially pinning benchmark 10-year yields near 0% through the large-scale purchase of Japanese government bonds. While the bank has tweaked YCC twice in 2023, allowing greater flexibility as to where benchmark yields can trade, significant uncertainty remains as to whether it will be able to lift policy rates out of negative territory in what’s looking like an increasingly difficult macroeconomic environment next year.

A lot will hinge on whether the lift in inflationary pressures in 2023 will flow through to spring wage negotiations at the end of the March quarter in 2024, delivering a virtuous cycle of stronger wage growth flowing through to inflation on a sustainable basis. The BOJ hopes this will help defeat the deflationary mindset Japanese consumers and businesses have become accustomed to for more than three decades.

But normalizing policy carries significant risks

But with upstream price pressures such as corporate goods prices rolling over rapidly, with the inflationary pulse at the consumer level following suit, these pay negotiations may well take place in an environment where strong disinflationary forces are evident. You can see the evolution in year-on-year rates for corporate goods prices, which are the costs businesses charge each other, shown in red. Core CPI, which excludes fresh food prices and is the BOJ’s preferred inflation measure, is in black. While still above the BOJ’s 2% target, the year-on-year rate will decline rapidly in the coming months due to the impact of high base effects a year ago.

_{Source: Refinitiv Eikon}

Complicating matters, Japan’s domestic economy is anything but robust right now with private consumption and capital investment remaining weak in the September quarter. Japan’s trade exposed sectors have been the one shining light, but with the global economy slowing down rapidly and the yen strengthening against those of its major trading partners, the sustainability of that trend is highly uncertain. Put bluntly, it’s a significant risk for the BOJ to tighten policy in such an environment, potentially unwinding decades of attempting to generate inflationary pressures.

As things stand in late December, markets are pricing in 25 basis points of rate hikes into the JPY curve by the end of 2024, with the initial move expected in April once the BOJ has visibility on trends in wage negotiations.

US-Japan rate differentials elevated but compressing

Taking the outlook for policy rates above, it’s now time to see how that’s flowing through to interest rate expectations over longer timeframes.

The chart below from Refinitiv tracks the spread differential between US Treasury yields and Japanese government bond yields over a variety of tenors in the past year. While we know yield differentials play a key role in driving movements in USD/JPY, it’s useful to compare shifts across the rates curve given there’s no rule as to what timeframe can be used in carry trades.

In this instance, we’ve decided to look at 2-year yields, shown in black, to represent what’s occurred at the front-end of the curve. This reflects expectations on the evolution of central bank policy rates in the future. Further out, five-year spreads are shown in blue. The “belly” of the curve reflects market growth and inflation expectations over a medium-term time horizon. 10-year spreads, shown in green, are the differential in benchmark government bond yields. It takes the signal from the belly but include a term “premium”, the additional compensation demanded to fund the Japanese and US governments over a longer timeframe, exposing them to higher levels of risk.

_{Source: Refinitiv Eikon}

The first thing you notice is US yields, compared to Japan, offer a significantly higher rate, reflecting where their respective central banks sit in the monetary policy cycle. However, the Fed’s dovish shift and growing speculation the BOJ may attempt to normalize policy has seen spreads compress since the mid-October, the moment the Fed first flagged financial conditions were reducing the need for them to hike further. Be it for 2s, 5s or 10s, the US yield advantage has fallen to levels last seen in the June quarter this year. That was when USD/JPY was trading in the low to mid-130s, rather than the low 140s where it presently resides. On that factor alone, it points to further downside risks for USD/JPY beyond what’s already occurred.

Navigating Grey Swan risks

Outside of yield differentials, another factor investors need to consider is the outlook for asset prices; a considerably more challenging process, especially when Black Swan events are impossible to predict. With many assets priced for perfection on the assumption of a soft economic landing, should that not eventuate, it carries the potential to generate renewed market instability and repatriation of capital to Japan. While hard landing risks dominate outlooks, given the risks to corporate earnings and solvency, it may not be the greatest threat traders face in 2024.

While the Fed’s early dovish pivot towards rate cuts will reduce the risk of a hard landing for the US, it arguably increases the risk that progress bringing inflation back to target will stall, requiring far fewer rate cuts than what is being priced by markets. That would see bond yields back up, widening spread differentials with Japan. The uncertainty under this scenario is whether it would spark enough market turbulence to see Japanese investors repatriate capital from the US, temporarily negating an increase in yield spreads that would normally push USD/JPY higher. The answer is probably no unless the rate recalibration occurs rapidly.

USD/JPY 2024 outlook

Looking at the momentum in the US economy, and how rapidly financial conditions are turning accommodative, directional risks for US-Japan yield spreads over the next year maybe skewing higher, regardless of whether the BOJ manages to normalize. And while that may challenge US asset valuations and spark carry trade unwinds, that would likely require negative spillover effects to regions where the growth outlook is considerably more challenged to eventuate.

As such, it suggests much of the correction in USD/JPY may have already taken place with the rapid recalibration in the US rate outlook. The overall bias remains lower in the year ahead, albeit not substantially so. Think the mid to high 130s for a year-end forecast, unless we see a hard landing which could see the pair return to pre-pandemic levels.

140.80 is the first downside level to watch, especially given the proximity of the 50-week moving average that was respected on several occasions this year. Below, 137.70 has acted as support and resistance for well over 12 months with 134.00 the next level under that. On the topside, USD/JPY may struggle to advance much past 145.00 unless the higher for longer narrative resurfaces again.

_{Source: TradingView}

Written by David Scutt, Market Analyst

Follow David on X: @Scutty