In early May, the Japanese yen saw a momentary rebound following intervention from the Bank of Japan, only to find itself weakening again in recent weeks, nearing historic lows against the US dollar. With the USD/JPY exchange rate approaching the critical 160 mark, the currency's trajectory raises new concerns among investors and economists alike.

As of last week’s closure, the USD/JPY was recorded at 157.01. At the beginning of May, the yen had been hovering around the 150 mark due to the interventions, yet, driven by a stronger dollar and waning expectations for Federal Reserve rate cuts, coupled with declining inflation figures from Japan, the yen began its slide. Notably, Japan’s Consumer Price Index (CPI) for April showed a year-over-year decrease from 2.7% in March to 2.5%. More alarming is the core inflation rate, excluding fresh food items, which dropped from 2.6% to a mere 2.2%.

It's essential to highlight that on May 24, the offshore yuan's midpoint fell below 7.11, reaching a four-month low. Financial reports indicated that the yuan had begun acting like a low-interest currency, a shift that has intensified its correlation with the yen in recent years. As the US dollar regained strength, the offshore yuan once again fell to around 7.26. This intricate relationship suggests that while Federal Reserve policies are closely monitored, the yen's movements may also provide insights into the yuan's performance.

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As the Japanese yen teeters close to the 160 mark against the dollar, the dynamics of Japan’s inflation are not aligning with the Bank of Japan’s hopes. The anticipated rise in inflationary pressures seems to be fading, especially as significant wage increases that might boost overall demand remain out of reach. Analysts express concern that the cycle of rising wages driving inflation might not sustain itself in the short term, which is precisely what has underpinned the yen’s past appreciation expectations.

Matt Weller, Global Research Director at Gain Capital, emphasized that although Japan’s core data for April met expectations, it still exceeded the Bank of Japan's target of 2%. However, there has been a notable drop—a complete two-percentage-point decrease since reaching highs earlier in the year. The CPI, excluding energy and food, has similarly shown significant deceleration, falling from 2.9% in March to 2.4%.

Weller noted, “As Japan's economy contracted in the first three months of the year, the hope for sustained inflation primarily hinges on the household sector. Positive growth in real wages would provide a necessary boost to the sluggish household spending. If that hope doesn’t materialize, additional rate hikes from the Bank of Japan seem implausible. Even with a weakening yen, upstream price indicators are showing minimal signs of widespread consumer price increases.”

This poses a dilemma for both the Bank of Japan and market participants as expectations of a 15 basis point hike around the year-end add to ongoing uncertainty. Meanwhile, strong economic data from the US has led to a drop in expectations for Fed rate cuts, causing yield differentials between the two currencies to remain at historic highs and prompting traders to continue buying the dollar on dips.

Within this context, the USD/JPY is once again nudging the 160 threshold. This vast depreciation of the yen had previously occurred in April, and now bearish sentiments appear to be resurfacing. In the week ending April 29, enormous fluctuations were observed in the yen’s value—prompted by a less hawkish than anticipated statement during a Bank of Japan meeting. Consequently, the dollar against the yen surged by 2.3%, breaching 158 and hitting highs not seen since 1990, though it later plummeted back down to around 156.

Many traders conveyed to reporters that the Bank of Japan does not intend to reverse the yen's trend but seeks to prevent an overly rapid depreciation in the short term, illustrating the circumstances under which intervening might be considered in the future.

Some expert opinions suggested that in early May, the Bank of Japan's account potential decrease of 7.56 trillion yen (equivalent to 48.2 billion USD) surpassed expectations by a wide margin, indicating that the central bank had effectively intervened around 5.5 trillion yen.

“After the suspected intervention from the Bank of Japan, the USD/JPY briefly dropped below 152, but subsequently, over the following two weeks, began a steady climb again. This uptick wasn’t because of any action taken by the Bank of Japan; rather, it was due to delays in the anticipated Fed rate cuts, allowing the US-Japan yield spread to maintain at relatively high levels. For bulls, 158 is the next target, and breaking through could trigger another challenge at the 160 mark,” Weller stated.

A crucial factor driving the yen's weakness has been the shifting expectations regarding US rate cuts. This year alone, these expectations have been quite volatile. However, the consensus currently appears to be leaning toward the view that it will be challenging for US inflation to decline substantially. The Fed, intent on curbing inflation, is more likely to delay any rate cuts to ensure inflation does not reignite.

As of last Thursday, the dollar index made a three-day rebound, nearing the 105 mark. The minutes from the latest Fed meeting highlighted that the pace of inflation decrease was falling short of expectations and that policy rates would need to remain at current levels for an extended duration, with some participants expressing a willingness for further tightening. As a result, rate cut expectations within the market sharply receded.

The meeting's minutes exceeded market forecasts. The dollar made a comeback while the commodity surge faced temporary cooling. Gold saw a nearly 2% decline overnight, silver dropped close to 4%, and copper plummeted about 5%. Concurrently, other non-dollar currencies—including the yen and the yuan—also broadly depreciated in value.

With a relief in both job demands and layoffs, the weekly initial jobless claims in the US, as of May 18, further decreased—down by 8,000 from the previous figure, marking the largest consecutive drop since September of last year. Presently, traders are predominantly focused on the upcoming PCE price index announcement, which holds significant weight for the Fed.

Moreover, many institutions are beginning to believe that one April CPI decline will not suffice to justify a rate cut. The Fed is likely to require 2-3 months of satisfactory data before considering any action. Thus, increased expectations suggest that the first potential rate cut may not appear until September, rather than June, with forecasts now leaning toward a single rate cut within the year.

Arend Kapteyn, Global Chief Economist at UBS, recently noted, “The Fed is monitoring PCE inflation closely, where housing rents hold considerable weight, so it shouldn’t easily be disregarded. There seems to be a consensus forming around a cooling labor market, and a slight uptick in unemployment could help eliminate some of the residual inflationary pressures, guiding the US economy towards a potential 'soft' landing. By the autumn, we should have adequate evidence of economic slowdown and improved inflation to support a rate cut.”

However, he cautioned that risks persist, including an economy that fails to cool or core inflation remaining closer to 3%. A further decline in unemployment could also complicate the case for a rate cut. UBS believes that should such scenarios unfold, it could signal a return to rate hikes in 2025, thus avoiding an economic 'landing' altogether. This scenario is not the base case but is certainly within the realm of possibility.

The yuan has mirrored the yen's recent downturn. Industry insiders emphasize the need for close observation of the correlation between the two currencies. On May 24, the yuan’s midpoint settled at 7.1102, marking over a four-month low. Liu Yang, the General Manager of Zheshang Zhongtuo Group’s financial market department, stated, “On May 23, the midpoint was at 7.1098, nearing the volatility zone's upper limit. As such, it remains crucial to monitor the yuan's potential for continuous slight fluctuations in the foreseeable future. However, excessive volatility may remain unwelcomed, as the Chinese central bank still expresses a strong commitment to maintaining currency stability.”

Liu further elaborated that the correlation between the yuan and yen has garnered increased institutional attention, driven by the current conditions where the dollar functions as a high-interest currency while the yuan has transitioned to a lower-interest status. Consequently, the latter has increasingly become a financing currency for enterprises, notably in scenarios where companies borrow in yuan to invest in dollar-denominated high-yield assets. “In the onshore market’s carry trades, the yuan is evidently becoming the borrowing currency as the logic guiding research and transaction activity has shifted,” Liu explained.

For many years, the yen has been characterized by its low-interest policy, firmly entrenching its role as a traditional financing currency. In carry trades, investors borrow in yen to subsequently invest in dollar assets. “The long-term decline in yuan interest rates appears to have established a market consensus, with foreign investments becoming increasingly sensitive to these changing dynamics. This is why, over the past two years, the movement of the yuan’s exchange rate has closely mirrored that of the yen,” Liu remarked.

Looking ahead, various quarters anticipate that the Chinese central bank will ensure ample liquidity, potentially prompting further reserve requirement ratio cuts, alongside deploying the MLF and other liquidity tools. UBS also suggested that if existing policy measures prove inadequate, additional actions from the government could follow suit.