Yen's struggle against dollar to persist as Japan ends negative rates

The long-struggling yen appears to have little upside in its future against the US dollar even as Japan has pushed its benchmark interest rate higher for the first time in 17 years.

The Bank of Japan (BOJ) moved away from negative interest rates on March 19, hiking rates for the first time since February 2007, and pushing the dollar-to-yen rate to levels last seen in November 2023. Japan's central bank will also formally end the policy to keep shorter-term yields low through asset purchases, though it will continue to buy Japanese government bonds.

The yen has performed the worst of any currency of the Group of Ten nations against the dollar since the US Federal Reserve began hiking rates from near-zero levels in March 2022. Currency strategists doubt a turnaround is on the horizon, as a move up for the yen would likely come from the Fed cutting rates as the BOJ raises them, and neither central bank has made firm commitments on their respective paths forward, potentially limiting any strength the yen could see from Japan's policy shift.

"Clearly the BOJ's inability to outline a potential time frame for more rate hikes has been a disappointment for the market," Jane Foley, head of foreign exchange strategy at Rabobank, said in an interview. "While most other G10 central banks tend to adjust policy progressively over a period of time, the BOJ is not in a position to signal that that is on the cards."

Another rate hike from the BOJ is possible this year, but Japan's economy remains weak and further rate moves will hinge on an improvement in Japanese economic data, particularly an improvement on real wage data that has been negative for nearly two years, according to Foley.

"The realization that policy normalization in Japan will be slow suggests limited upside potential for the [yen] this year," Foley said.

High bar

With inflation and soft economic activity improving, the BOJ is unlikely to hike beyond market expectations of 20 basis points over the next 12 months, with some BOJ policymakers preferring to return to negative interest rate policy instead, said Elias Haddad, a senior markets strategist with Brown Brothers Harriman.

"Indeed, the bar for an aggressive BOJ tightening cycle is high," Haddad said in an interview.

In addition, expectations for the Fed's benchmark federal funds rate have been adjusted higher, which will likely be a boost to the dollar and US Treasury yields. If the Fed indicates that it is more reluctant to cut rates than the market previously expected, the dollar will be "turbocharged" and the dollar-to-yen rate will rise to levels last seen in October 2022, Haddad said.

The Fed is not expected to cut rates at its meeting this week, but scheduled updates to its quarterly projections may signal how much the Fed plans to cut this year and the next. The dollar has rallied as inflation and jobs data have come in hotter than expected, boosting the likelihood that the Fed will push back cuts and keep interest rates at relatively high levels for longer than previously anticipated.

The dollar tends to rise with interest rates as investors move to government bonds and other dollar-denominated securities. A robust US dollar helps lower the cost of foreign goods while increasing the price of US exports and chilling global demand. A rally in the US dollar in 2022 added pressure to inflation worldwide and increased the costs of foreign debt service.

Much will depend on the direction of inflation in the US, according to Lee Hardman, senior currency analyst with MUFG Bank.

"If US inflation slows in the coming months as we expect, then USD/JPY is likely to correct back lower as well as the Fed remains on course to begin cutting rates in June," Hardman said. "However, if US inflation disappoints again in March, then it would become more likely that the Fed could wait until the second half of this year to begin cutting rates and continuing to encourage further upside for USD/JPY in the coming months."