We’re not losing sight of the prospect that dollar/yen will slide to 120, or even lower.

But sometimes the market looks for US dollar story when there really isn’t one. This is the case at the moment, for while much of the currency market narrative seems to be about dollar strength, the real story is one of yen weakness.

If you look at events in recent years, such as the pandemic and the war in Ukraine, it is easy to see how this has moved asset prices like bonds and stocks around in a pretty dramatic way. But G10 currencies have been remarkably stable, bar one – the yen. The real effective exchange rates of dollar, euro and pound have all basically flatlined over the past 5-years or more. That’s quite extraordinary given the huge shocks we’ve seen, such as the pandemic, which have led to massive fiscal and monetary policy changes and huge volatility in asset prices such as stocks and bonds. Why has it happened? Most probably it reflects the fact that currencies are a function of relative fundamentals, not absolute fundamentals. What do we mean by this?

If there is a massive shock, like a pandemic, it causes absolute fundamentals to change dramatically as economies plunge and policy is eased massively to cope with the shock. But, if all countries are doing this together the change in relative fundamentals is limit ed and, if currencies reflect these relative fundamentals, their movement is limit ed as well.

The pandemic was a clear case of a symmetric shock as all countries were impacted in the same way and hence the policy response and impact on asset prices like bonds and stocks was similar as well. The shock of the war in Ukraine was slightly different as this was more asymmetric as the US was not as hard hit as Europe, but even here the currency market dislocation amongst currencies such as the euro and the dollar was both temporary and quite limit ed.

Unsurprisingly, if we want to find significant currency volatility we have to look to see where economic and policy asymmetries have been both large and persistent, and this is where yen weakness comes in. Japan’s refusal to follow the rate hikes of other central banks has clearly driven a huge wedge between the performance of the yen and other developed currencies.

As a result, the real trend in FX markets in recent years is yen weakness, not dollar strength as the yen is shunned due to its low yield while previously hedged yen sales for higher-yielding currencies become unhedged due to the high cost of borrowing foreign currencies. But why do we mention this?

“We’re talking about it because it seems likely to us that, as long as relative differences in things like economic performance and policy between the US and Europe is limit ed, so too will be the volatility in the likes of euro/dollar and sterling/dollar. Now, of course, there is some ‘wiggle’ room here as supposed US “exceptionalism” seems to be giving the dollar support at the moment, but it does not seem likely to us that this is going to be sufficient to lift the US dollar significantly. Instead, it seems more likely that the key will be the weakness of the yen, with the currency likely to cede more ground if the Fed and others have to keep rates higher for longer”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.

However, just as we saw a year ago, excessive yen weakness can prompt BoJ intervention and, as this is concentrated in US dollar/yen it can – as we saw a year ago – provoke a weaker dollar against other currencies as well, such as the euro and pound. But in addition to this point there’s also a question mark over what happens to the yen once the BoJ’s relatively easy monetary policy position reverses, which may be because the BoJ lifts rates or, more likely, because others ease. This could unleash a significant rally in the yen.

Hence we’re not losing sight of the prospect that dollar/yen will slide to 120, or even lower. But this will take time and, all the while, it seems likely that the relative stability that exists between the US and Europe will keep the dollar contained against the euro and the pound.