Source: Finance Association

If we were to talk about which country's financial market performance was the most notable in the first quarter of this year, then the answer is undoubtedly Japan — just last month, the Nikkei 225 index just broke its 34-year high record; and this week, the yen also became the focus of the global financial media spotlight: it once collapsed to a new low in nearly 34 years during the morning of the day!

This scene is more or less surprising to some foreign exchange traders: it is clear that the Bank of Japan just ended negative interest rates last week and announced interest rate hikes for the first time in 17 years. Why did the yen rapidly expand its decline after the central bank raised interest rates?

According to market data, the US dollar hit a high of 151.97 against the yen in the morning of the day, surpassing 151.95, which triggered direct foreign exchange intervention by the Bank of Japan in October 2022. This is also a high level that the pair has not touched since July 1990.

The sharp fall in the yen has unquestionably raised the risk of intervention by the Japanese authorities. But right now, perhaps the more pressing question is:

What exactly is causing this wave of market decline in Japan?

Is it true that only the Japanese yen faces the risk of depreciation in the global foreign exchange market?

What does the sudden appearance of a strong dollar actually mean in a year when the US Federal Reserve cut interest rates?

Why did the yen “collapse”?

First, let's answer the first question: Why did the yen collapse?

The answer may or may not be complicated — market participants suddenly realized one thing after the Bank of Japan's decision this month: ending negative interest rates will not actually save the yen; on the contrary, the Bank of Japan's interest rate hike, which originally hangs “above the head” of the US dollar against the yen, once the real boots have landed, it's completely impossible for the Japanese yen bears to feel like they are being scammed!

In fact, one widely accepted opinion in the current market is that although the Bank of Japan delivered a series of austerity punches last week to “end negative interest rates, cancel yield curve control (YCC), and stop ETF purchases,” the Bank of Japan's future austerity actions will continue to be gradual and slow. The country's long-term outlook for monetary easing will not be completely reversed, especially compared to central banks in other economies where interest rates are currently at their peak for decades.

This can also be confirmed in today's speech by an official claiming to be the “most hawkish” within the Bank of Japan.

Bank of Japan Review Member Naoki Tamura (Naoki Tamura) said on Wednesday that the way to manage monetary policy is essential to slowly and steadily normalize policy and end large-scale monetary easing. However, he also pointed out that the relaxed environment in the financial market is likely to continue, and there is less risk of rapid interest rate hikes. Normalization means restoring the function of interest rates affecting the economy and achieving the 2% inflation target. After its speech, the yen clearly extended its decline.

In the hawk pigeon camp in the industry, Naoki Tamura is the most hawkish figure among the nine members of the Bank of Japan's board of directors. But there's no doubt that his latest speech wasn't as “eagle” as people might think.

In Tamura's latest speech, he did not give a clear hint about the next normalization measures to be taken. According to most Bank of Japan observers, the next time the central bank cuts interest rates will be at least until October of this year.

This indicates that for most of this year, the yield gap between US treasury bonds and Japanese treasury bonds will probably remain above 400 basis points for a long time, and the return on “arbitrage trading” may still be quite impressive. Currently, the yield on US two-year treasury bonds is about 4.593%, while the yield on Japanese two-year treasury bonds is about 0.191%, which makes dollar-denominated assets more attractive, that is, investors borrow cheap yen in exchange for US dollars to invest in higher return assets.

Is the sharp drop in yen just the most typical “microcosm” of the global foreign exchange market pattern?

Judging from the current situation, if the yen weakens further in the future, it will probably trigger intervention by the Japanese authorities.

Regarding the recent fluctuations in the Japanese yen, Japanese officials are now issuing warnings about speculation in the foreign exchange market almost every day. Japan's Finance Minister Shunichi Suzuki recently stated that he will closely monitor foreign exchange fluctuations with a high sense of urgency and take bold action on exchange rate issues when necessary.

“The market is very sensitive to the 152 region,” said National Australia Bank strategist Rodrigo Catril. “If we break this level, then recent history shows that intervention is much more likely.”

In addition, many market participants believe that the region where the Bank of Japan is more likely to take action is at the 155 mark. Bank of America believes that if the USD/JPY exchange rate reaches the 152-155 range, the risk of intervention will increase, while Bloomberg's survey of economists suggests that the exchange rate level that prompted Japan's Ministry of Finance to intervene is expected to be 155.

Fundamentally, however, any intervention may end up being just a remedy for the symptoms rather than the root causes. The Bank of Japan directly interfered with the yen exchange rate twice in September and October 2022. But that didn't change one event: the yen once again became the worst of the G10 currencies last year, and this is still the case this year.

Now, if people look at the world, one point they probably need to worry even more is that the yen, which has been falling all the way during the year, will it just be the most typical microcosm of the pattern of strength and weakness in the global foreign exchange market?

Judging from the trend during the year, the US dollar index has accumulated a cumulative increase of nearly 3% over the first two months of the year. This increase is not very large when measured from a monthly perspective — last year and the year before, people have clearly seen times when the dollar rose more fiercely. However, if we leave aside the overall performance of the US dollar index and look at the rise and fall of the major non-US currencies, it is easy to see that the strength of the US dollar so far this year has actually been quite “dominant.”

The chart below covers the rise and fall rankings of 35 major global currencies against the US dollar during the year. What many people might not expect is that only two non-US currencies — the Kenyan shilling and the Mexican peso — have risen against the US dollar this year. All other non-US currencies have declined except the Saudi riyal, which is linked to the US dollar.

Looking at this dimension, although many domestic investors are also worried about the recent depreciation of the RMB, in fact, the RMB is still in a relatively strong position among the overall non-US currencies this year — it can still rank in the top ten of the list of gains and losses.

Instead, they are some other Asian currencies, which seem to be following the Japanese yen's footsteps right now. For example, the won and Indonesian rupiah have now fallen to their lowest level since November last year. In terms of correlation, the 60-day correlation index between the won and yen has reached 0.35, the highest level since May 2023. The value is 1, which indicates that the two currencies move perfectly synchronously.

Why will the US dollar be strong during the year when the Federal Reserve cuts interest rates?

So, in a year where it is acknowledged that the US Federal Reserve cuts interest rates, why will a strong dollar emerge?

Since this year, some dollar-denominated assets, such as gold and bitcoin, can be said to have been exported in the face of strong dollar headwinds. However, it is clear that within non-US currencies, it is currently difficult to resist the “strength” of the US dollar. The reason behind all of this is actually much the same as the weak background that the yen is currently showing — interest rate spreads are still developing in favor of the US dollar.

In fact, after the Swiss central bank unexpectedly cut interest rates last week — after becoming the first central bank in the G10 to switch to easing, some keen investors in the foreign exchange market have already “woken up like a dream” — they are beginning to realize that the Federal Reserve may instead be one of the few central banks in the world that have maintained the “longest” peak interest rate.

Let's first take a look at the G10 central banks. Currently, only the New Zealand Federal Reserve's interest rate (5.5%) is flat or higher than the Federal Reserve (5.25% - 5.5%); all others are lower than the Federal Reserve. Expectations for many central banks to cut interest rates during the year are also larger than those of the Federal Reserve. The most representative shift is the Bank of England — at the beginning of this year, the market always thought that the Bank of England would cut interest rates later than the Federal Reserve (this is also the reason why the British pound led the G10 currency for a long time), but as hawkish Bank of England officials abandoned insisting on further interest rate hikes last week and turned dovish, the market is currently betting on the Bank of England's interest rate cut in June.

What about the US Federal Reserve, which is hawkish among G10 central banks, compared to emerging markets?

Indeed, among emerging market central banks, the benchmark interest rate of many central banks is still higher than that of the Federal Reserve. This seems to be unfavorable to the US dollar in terms of interest rate spreads. But don't forget — the vast majority of central banks that have now entered a cycle of cutting interest rates are emerging market central banks, and many central banks have cut interest rates quite a bit; their policy changes may be much faster than the Federal Reserve.

This poses a serious problem: the Federal Reserve's interest rate is both higher than other developed central banks, and the interest-rate cut cycle starts slower than many emerging central banks. This also makes the US dollar invincible in the vast majority of cases, whether against other G10 currencies or emerging market currencies.

All of this directly contributed to the current situation in the first quarter of the year when the Federal Reserve cut interest rates, the US dollar is almost a rare rival in the foreign exchange market.

What's more, don't look at the median US Federal Reserve bitmap forecast released last week, still shows that interest rates will be cut three times during the year, but in fact, the exact comparison of official voting points is only 10:9. — whether it will actually cut interest rates three times or two, is actually still between the two...

If the US inflation data continues to show stickiness, and the number of interest rate cuts by the Federal Reserve during the year is estimated to be from six times at the beginning of the year to three times now, and even fewer in the future, then as an investor, you might as well guess — will the US dollar rise further in the future?

editor/tolk