Dollar’s Ascendancy Over Yen Fuels Overshoot Concerns, Intervention Risks Loom
The US dollar’s dominance over the Japanese yen has been a defining feature of the 2024 currency markets, driven by the divergent monetary policies of the Federal Reserve (Fed) and the Bank of Japan (BoJ). While the Fed has embarked on a path of interest rate hikes to combat inflation, the BoJ has maintained its ultra-loose monetary stance, creating a widening gap in interest rate differentials. This divergence has spurred a significant rally in the USD/JPY exchange rate, pushing it to multi-year highs. However, strategists at Bank of America (BofA) warn that this trend carries the risk of an overshoot before a potential correction materializes in the first quarter of next year.
BofA maintains a structurally bullish outlook on the USD/JPY pair, anticipating further appreciation in the long term. However, they also foresee a potential correction in the first quarter of 2025, primarily due to heightened uncertainties surrounding US economic policy. The key risk, they highlight, lies in the potential for the USD/JPY to overshoot its fair value before this anticipated correction, fueled by fading market expectations for a BoJ rate hike.
Market expectations for a BoJ policy shift have dwindled significantly in recent weeks. At the end of November, the probability of a rate hike at the BoJ’s December meeting was estimated to be over 60%. However, this figure has plummeted to just 16% following reports suggesting the BoJ’s inclination to maintain its current course. This shift in sentiment is attributed to uncertainties surrounding US economic policy and wage growth trends. The BoJ’s cautious stance further reinforces the prevailing divergence in monetary policy between the US and Japan.
The diminishing likelihood of a BoJ rate hike amplifies the risk of an excessive USD/JPY rally, potentially triggering intervention by Japan’s Ministry of Finance. BofA strategists point out that if the USD/JPY approaches the 155 level before the BoJ’s December meeting, the absence of a rate hike could significantly impact market perceptions of Japan’s currency policy. This could be interpreted as the BoJ’s tacit acceptance of a USD/JPY rate below 155, potentially emboldening further yen depreciation.
BofA anticipates that if the USD/JPY experiences a post-meeting rally following the BoJ’s December decision, the risks of intervention might be mitigated by thin liquidity conditions characteristic of year-end trading. However, the overall outlook for USD/JPY remains heavily influenced by the evolving dynamics between the Fed and the BoJ.
Looking ahead, the trajectory of USD/JPY will be closely tied to the interplay between these two central banks. A sustained divergence in monetary policy will likely continue to exert upward pressure on the pair. However, the risk of an overshoot and subsequent correction looms large, particularly if the BoJ maintains its current stance. The market will also be keenly observing any signs of potential intervention by Japanese authorities should the yen’s depreciation accelerate. The uncertainties surrounding US economic policy further complicate the outlook, adding another layer of complexity to this crucial currency pair.
