Renminbi Stability: How Long Under BoJ, Fed Rate Hikes?
On July 31, the Bank of Japan shook global markets by unexpectedly raising interest rates, moving earlier than the generally agreed consensus of a September increase. Alongside this decision, the central bank announced plans for a reduction in its bond purchasing program. This announcement propelled the Japanese yen to strengthen significantly against the U.S. dollar, with the USD/JPY pair nearing a critical level of 150. Interestingly, this development also affected other Asian currencies, such as the Chinese yuan, which appreciated over 300 pips in a single day.
The financial world was abuzz as investors awaited the U.S. Federal Reserve's rate decision, scheduled for early Thursday morning. While there was a strong consensus in the market suggesting the Fed would maintain current interest rates, the wording of the accompanying statement was highly scrutinized. Many were particularly focused on whether the Fed would adopt a more dovish tone going forward. Current market expectations indicated a projected 55 basis points in rate cuts for the entire year, with approximately a 90% probability of the first cut happening in September. This anticipation for rate cuts has caused U.S. Treasury yields to decline, consequently resulting in a struggling U.S. dollar index, which found preliminary resistance around the 104.80 mark.
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In the run-up to these significant announcements, traders in foreign exchange markets observed a notable shift in sentiment. Following a meeting of the Communist Party’s political bureau on July 30, which emphasized a stable economic environment, many market participants began to reevaluate their previous forecasts. Specifically, traders who once expected the dollar to hit new highs against the yuan within the year began to abandon those predictions. As the Japanese yen gained strength overnight into today, it provided a boost to the yuan, reinforcing the strong correlation between the two currencies. The carry trade strategy, which indicated borrowing in low-yielding currencies like the yuan and yen to invest in higher-yielding assets, seemed poised to reverse course.
The repercussions of Japan's surprise rate hike were felt immediately. Despite an early rebound of the USD/JPY pair above the 155 level on Tuesday, it quickly retraced all gains during the European and U.S. trading sessions, ultimately closing at 152.78, marking a two-month low. The market's volatility hinted at investors bracing for the Bank of Japan's actions. Sure enough, the central bank officially raised interest rates by 15 basis points on Wednesday, moving from a range of 0-0.1% to 0.25%, its highest level since 2008. Additionally, the Bank of Japan revised its inflation outlook for 2025 upward and kept the door open for future rate hikes.
The specifics of the bond purchase tapering plan were also made public, indicating a reduction of 400 billion yen per quarter, down from the current 30 trillion yen per quarter, aiming to achieve a monthly purchasing level of 3 trillion yen by the first quarter of 2026. However, the process may allow for adjustments along the way. Following the announcement, exchange rates briefly stabilized around the 153 level, with the critical support level now seen at 152. A breach below this could bring long-term trendline support near 149 into play, as noted by Matt Weller, Global Research Director for FX at Gain Capital.
In terms of investor sentiment following these developments, the Japanese stock market reacted positively, with the Nikkei 225 index surging by 1.59% to reach 39,123 points, particularly benefitting bank stocks likely to be sensitive to rate changes. Gary Dugan, CEO of The Global CIO Office, conveyed that the Bank of Japan's intentions to prevent yields from rising sharply should not be viewed negatively; rather, it signals a normalization of Japan's economy, which should be encouraging for domestic investors.
Earlier in the year, many expected that the Bank of Japan would wait until September for its next interest rate hike, as the effectiveness of recent strong wage negotiations to raise household incomes and consumption remained unproven. However, persistent weakness in the yen raised concerns, prompting the Bank to maintain options for interest rate adjustments to manage exchange rate pressures against a strong dollar backdrop.
In tandem with the Japanese yen’s rally, the yuan also exhibited robust performance against the dollar. The correlation between the yen and yuan has only strengthened throughout the year. On July 31, the yuan continued to gain ground against the dollar, showing a positive uptrend.
On July 25, the yuan had already experienced a substantial appreciation, triggered by the movements in the yen. During that day, the offshore yuan tracked a sharp decline in USD/CNY, falling from 7.2719 to as low as 7.2035, equating to a notable rise of over 600 pips. A foreign bank forex trader noted that recent activity in offshore markets featured a prevalent carry trade strategy, capitalizing on borrowing from low-interest currencies like the yen and yuan, to invest in higher-yielding assets such as the dollar. Yet, a significant squeeze on these positions emerged on July 25, boosting the yuan’s value dramatically.
This volatility was indicative of a rising demand for reduced leverage in the market, suggesting traders with previously crowded positions may have needed to lower their stakes. In the forex arena, a dominant strategy had involved the borrowing of low-interest currencies like the yen and Swiss franc while investing in high-yield currencies. With the uptick in volatility, the stability of these crowded positions came under pressure, compelling traders to unwind and reduce leverage.
However, some industry analysts cautioned that the correlation between USD/CNY and USD/JPY might not persist indefinitely. Liu Yang, a seasoned currency expert and head of the financial market division at Zhejiang Merchants Zhongtuo Group, remarked that while the yen and yuan might exhibit strong correlation due to being low-interest currencies, diverging monetary policies could see them part ways in the future. Thus, ongoing observation of policy changes is essential.
Liu added, “An increase in the yen's value does not necessarily mean the yuan will follow suit swiftly. If risk aversion drives the dollar index down ahead of the U.S. elections, the yuan may be influenced similarly.”
Furthermore, Zhou Yutian, Director of Multi-Asset Investment at Aberdeen, articulated concerns regarding Japan's economy remaining relatively weak, suggesting that the yen's strength could be ephemeral. With prior interventions by the Japanese Finance Ministry leading to the USD/JPY pair retreating from levels around 162, and the Fed's anticipated rate cuts providing support for the yen amid a weakening dollar index, the market awaits clarity on upcoming macroeconomic indicators. As computing forecasts, the potential for additional unwinding of carry trades prior to the Fed's meeting is plausible, but if recession risks in the U.S. fail to materialize or the Fed does not announce a more dovish stance than the markets expect, sustained appreciation of the yen may appear unlikely. Historically, unless the Bank of Japan signals a definitive hawkish stance regarding future rate increases, the dollar remains likely to appreciate against the yen regardless of monetary policy changes.
This week has undoubtedly emerged as a "super central bank week," with the Fed's upcoming decision being the focal point of market disturbance. On August 1, the Federal Reserve will unveil its rate decision, with the prevailing consensus indicating that the current rates will remain unchanged. However, the potential for a more dovish statement continues to attract significant interest. Recent trends in inflation data should bolster the Fed's confidence as analysts foresee increased probabilities of a rate cut in September. With futures markets pricing in more than five cuts in the year ahead, the implications for global currencies are critical.
Matt Weller indicated a blend of favorable and unfavorable U.S. economic data, particularly highlighting the unexpected decline in June’s CPI as cause for an immediate rate cut decision, although it’s expected that the Fed may choose to wait a bit longer. He noted that the uptick in first-time jobless claims illustrates a downward shift in the labor market's risk balance. While core PCE inflation may exhibit stickiness, a lack of growth for 11 consecutive months in core PCE inflation emphasizes the shifting economic conditions.
In summary, as inflation nears the Fed's target and labor market risks escalate, the rationale for an immediate reduction in rates is compelling, even if the Fed may prefer to act with caution given past experiences with inflation. Coupled with the Bank of China’s recent rate cuts, including adjustments to reverse repurchase rates, LPR rates, and MLF rates, there are significant liquidity measures in place aiming to stimulate economic momentum while alleviating potential downward pressure on the yuan amidst evolving global rate expectations.