The yen faces an uncertain future

While central banks around the world are lowering interest rates, the Bank of Japan will actually raise its key rate later this year. It is only a matter of time before currency traders start positioning themselves for a policy shift in the Asian country.

There is little sign of a quiet holiday period in currency markets. At the end of last week, the Japanese yen attracted attention. The currency rose by over 2% against Western currencies such as the dollar and the euro. This surge was not caused by an interest rate decision or a geopolitical event like an unexpected election result for once. Instead, the yen received a powerful boost as the central bank intervened in currency markets. Data released by the Bank of Japan (BoJ) on Friday showed that over 3.5 trillion yen - about €20 billion - worth of support purchases were made. However, previous interventions were insufficient to halt the yen's free fall.

Drop in the bucket
Since the beginning of 2021, the Japanese currency has fallen by 35% against the dollar. Compared to the euro, the depreciation stands at 27%. The difference is explained by the fact that inflation flared up three years ago in the Western world. In response, central banks in the United States and Europe raised policy rates significantly to 4% or even higher. Meanwhile, the Japanese rate has crept up from -0.1% to 0.1%. For savvy financial entities, it is very attractive to borrow money in Japan and invest it in another region with higher returns. As long as this so-called carry trade continues, the BoJ's support purchases are just drops in the bucket.

July 30: an important day for the yen
However, change seems to be slowly but surely on the horizon. On July 30, the BoJ board will convene for a policy meeting. The likelihood of another increase in the policy rate after the hike in March is quite low. But an important signal will be sent if there is preparation for a rate hike later in 2024 along with the phasing out of support measures. Currently, the BoJ is still buying 5 to 7 trillion yen worth of government bonds and other assets every month in an attempt to boost inflation. By now, that goal seems to have been achieved. In May, inflation rose from 2.2% to 2.5%.

Will the policy shift happen?
If the central bank clearly signals a policy change, it is a sign for traders to start unwinding their carry trades. This movement could gain momentum if Western central banks slightly reduce policy rates in the course of 2024. This also contributes to narrowing the interest rate gap between Japan and the rest of the developed world. Slowly but surely, the tide seems to be turning for the yen after the significant depreciation in recent years. Before that happens, the BoJ must first convince the currency world that the policy shift will indeed take place. Until then, the bank is clearly swimming against the current with any form of support for the yen.

Joost Derks

Joost Derks is a currency specialist at iBanFirst with over twenty years of experience in the foreign exchange market. This column reflects his personal opinion and is not intended as professional (investment) advice.

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