HSBC warns: Yen structurally weak, no quick fix in sight. Expected to fall to 160 yen to the dollar by mid-year.

Japanese Prime Minister Takaichi Sanae officially confirmed at a press conference on Monday that the House of Representatives will be dissolved on January 23 and an early election will be held on February 8. The Prime Minister, who supports expansionary fiscal policy and loose monetary policy, also stated that bold investment risk management is necessary to break free from excessive austerity constraints. Concerns about the sharp expansion of Japanese government spending and the resurgence of inflation are causing the traditional correlation between the Japanese yen and the US dollar and government bond yields to break down, prompting strategists at HSBC HOLDINGS to change their forecasts for the future trend of the Japanese yen over the next few months. Global investors generally believe that the Japanese yen is closely related to interest rate differentials, and that the yen will be supported when the interest rate spread between Japan and the US narrows. However, this pattern has not been evident in recent months. In fact, since early October last year, the Japanese yen has depreciated by about 7% against the US dollar - despite a narrowing yield spread of nearly 60 basis points between 10-year Japanese government bonds and US bonds. HSBC FX strategists led by Paul Mackel and Joey Chew stated, "This 'wedge difference' between the two reflects an expansion of the yen's 'risk premium.' The strategists noted that since Takaichi Sanae became Prime Minister last year, investors' concerns about the yen's "structural weakness" include debt monetization, declining purchasing power, and ongoing inflation and negative real interest rates. These concerns were particularly evident in the selling of Japanese government bonds on Tuesday. On that day, Japanese government bond yields soared, prompting Japanese Finance Minister Otokizuki Katsumi to urge market participants to remain calm. Meanwhile, in the background of "selling US assets," although the US dollar weakened overall and US stocks and bonds fell together, the yen performed worse than all other G10 currencies and depreciated slightly to around 158 yen per US dollar. HSBC strategists believe that there are two catalysts for the sudden clearance of the yen. First, is the significant increase in Japanese inflation since 2022. Secondly, is Takaichi Sanae taking office as Prime Minister last October and planning to hold a national election in early February to consolidate support for his stimulus policies, including a record initial budget of around 122.3 trillion yen (about $775 billion). HSBC strategists currently expect the yen to depreciate to around 160 yen per US dollar by the middle of the year, whereas previous strategists had expected the yen to strengthen to around 150 yen per US dollar. HSBC strategists also pointed out that if the yen falls below 160 yen per US dollar, Japanese authorities may intervene in the forex market to support the yen, making the outlook more complicated. However, HSBC strategists also pointed out that there are a few potential factors that may prevent the yen from continuing to fall in the short term, but the most feasible factors, such as a slowdown in the US economy, are not within the control of Japanese policy makers. Other potential factors include: positive real yields at the front end of the Japanese government bond and inflation curve; "credible fiscal consolidation plans or at least stronger signs of fiscal discipline"; and "checks and balances in parliament - more voices opposing aggressive fiscal expansion"; negative external factors such as declining real yields in the US and a shift towards dovishness by the Federal Reserve, as well as rising fiscal risks in other major economies; and "credibility of the Bank of Japan's symmetry in policy." HSBC strategists concluded, "The shift of the yen towards a fiscal dominance system is not a fait accompli. But we can understand why market concerns are difficult to dispel in the short term." Political earthquake in Japan combined with central bank interest rate meeting On the same day that Takaichi Sanae dissolved the House of Representatives, the Bank of Japan will announce its latest interest rate decision. The market generally expects the Bank of Japan to keep the benchmark interest rate unchanged on Friday, which will not directly support the yen. The focus of this meeting will be how hawkish signals Governor Ueda Kazuo will release as the yen approaches a key level against the US dollar. According to sources reported last week, Bank of Japan officials are paying more attention to the impact of yen depreciation on inflation, as further yen depreciation could push up prices and accelerate future rate hikes. Naka Matsuzawa, chief strategist at Nomura Securities, said, "The Bank of Japan may indicate that the threshold for the next rate hike will not be high to avoid exacerbating yen depreciation. They may leave room for action, possibly as early as April." Akira Hoshino, head of Citi's Japanese markets, also said that if the weak yen situation continues, the Bank of Japan could raise rates three times this year. If the yen continues to fall, traders will be highly vigilant about the possibility of the Japanese government intervening in the forex market as early as that day. Last week, Japanese Finance Minister and Japan's highest foreign exchange official both issued warnings to speculators on Wednesday. Japanese Finance Minister Otokizuki Katsumi said, "We will not rule out any measures and will respond appropriately to excessive, including speculative, exchange rate fluctuations." She hinted that direct intervention in the market is one of the options, stating that "we have already informed the Prime Minister of this." She added, "The sudden fluctuations we saw on January 9 were unrelated to fundamentals, which is deeply concerning." Japan's top foreign exchange official, Jun Mimura, also expressed support for Otokizuki Katsumi's remarks, reiterating that no option is ruled out. With the yen continuously weakening and approaching the level when the Japanese government last intervened to support the yen in July 2024 - around 160 yen per US dollar, traders have been highly alert to any substantive measures the Japanese authorities may take to intervene in the forex market. However, Japanese officials have repeatedly emphasized that there are no specific intervention points, and that the purpose of any action is to curb excessive or sudden fluctuations. Therefore, the market focus on Friday is likely to be on Governor Ueda Kazuo's press conference. Traders will closely monitor whether the situation will be similar to September 2022. At that time, former Bank of Japan Governor Haruhiko Kuroda's comments after maintaining policy stability led to further yen weakness. However, less than an hour after the press conference, the Japanese Ministry of Finance intervened in the forex market for the first time since 1998. Tsuyoshi Ueno, chief economist at NLI Research Institute, said, "I am closely watching for signs of a hawkish bias or warnings related to yen weakness." Ueda Kazuo needs to carefully weigh his decisions. Ryutaro Kono, chief Japan economist at BNP Paribas, said that given Takaichi Sanae's inclination to support loose monetary policy and with the general election approaching, Ueda Kazuo may not reveal information about accelerating rate hikes at this time. However, if he is too dovish, yen bears will seize the opportunity. Additionally, the Bank of Japan will also update its quarterly economic growth forecasts this week. Sources revealed earlier this month that, due to the massive economic stimulus package pushed through by Takaichi Sanae in December, officials may revise up the economic growth forecast. Economists surveyed expect that although the recent depreciation of the yen has brought upward pressure, the Bank of Japan will not make major adjustments to its price expectations. The Bank may maintain its expectation of achieving the 2% price target in the latter half of the three-year forecast period ending in March 2028.