The complexities of global currency dynamics are constantly shifting, particularly evident in the recent tumultuous trajectory of the Japanese yen. In early May, following reports that the Bank of Japan (BoJ) was considering intervention strategies, the yen saw a fleeting surge before succumbing again to weakness, bracing itself for another confrontation with historic lows against the US dollar, with the dollar-yen exchange rate inching towards the ominous 160 mark.

As of last week's market closure, the dollar-yen rate stood at 157.01. It’s worth noting that during the period of intervention in early May, the exchange dipped near 150. However, recent trends amplified the dollar's strength, fueled by cooling expectations around Federal Reserve interest rate cuts and a decline in Japanese inflation metrics, leading to renewed depreciation of the yen. April's Consumer Price Index (CPI) data revealed a year-on-year inflation decrease from 2.7% to 2.5%, with core inflation, excluding fresh food prices, softening markedly from 2.6% to 2.2%.

On May 24, the Chinese yuan also felt the pressure, as its central parity rate fell below 7.11, marking a four-month low. Observations suggest a growing trend of interconnectedness between the yuan and the yen, particularly as the yuan has now entered the realm of low-interest currencies. With the dollar’s resurgent strength and the yuan falling back to around 7.26 offshore, the implications for the yen's performance could provide significant insights on the yuan's trajectory moving forward.

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As the yen’s downward spiral approaches the critical threshold of 160, it raises alarm bells regarding Japan's inflation trajectory, which has not evolved to favor the Bank of Japan's objectives. The earlier expectations for persistent inflation appear to be waning, reducing the likelihood of substantial wage increases necessary to stimulate overall demand. Analysts are skeptical that the price pressures observed will foster a sustainable feedback loop of wage growth and inflation—a dynamic that had underpinned bullish projections for the yen.

Matt Weller, Global Research Director at Gain Capital, emphasized that while April's core data met initial expectations, they still exceeded the BoJ’s target of 2%, albeit lower than the peaks observed earlier this year. Notably, the CPI excluding energy and food has also witnessed pronounced deceleration, showcasing a drop from 2.9% in March to 2.4%—a significant shift.

“Given the contraction of the Japanese economy in the first quarter, the hopes pinned on inflation largely rest on the household sector. Positive growth in real wages would be beneficial for the weakened domestic spending,” Weller articulated. Absent these conditions, the prospect of further rate hikes from the BoJ remains grim. Even as the yen depreciates, upstream price indicators exhibit minimal signs of a broad-based uptick in consumer prices.

This poses challenges for both the Bank of Japan and market participants, as expectations mount for an approximate 15 basis point rate increase next year. Concurrently, robust data from the US has diminished the likelihood of any imminent rate cuts from the Federal Reserve, leaving the yield differential between the two nations persisting at historically elevated levels, emboldening traders to continue buying dips.

In this light, the dollar-yen exchange rate is once again flirting with the 160 threshold. Notably, a significant depreciation wave was observed in April, and the re-assertion of bearish sentiment appears to be taking hold once more. The last week of April realized dramatic fluctuations, largely triggered by the BoJ’s meeting not delivering hawkish expectations, with shorts driving dollar-yen up 2.3% past the 158 mark, momentarily touching 160—its highest level since April 1990—before retreating sharply to near 156.

Several traders noted that the BoJ remains disinterested in reversing the yen's trend but strives to prevent an overly rapid depreciation in the short run, thereby hinting at potential conditions under which future market interventions could occur.

Speculative angles arise suggesting that the BoJ's accounts may have decreased by as much as 7.56 trillion yen (approximately US$482 billion). If true, this figure surpasses previous expectations of around a 2.1 trillion yen drop, indicating intervention somewhat exceeding 5.5 trillion yen.

“After the BoJ's suspected intervention, the dollar-yen dropped below 152, only to exhibit a steady uptrend in the following fortnight—not due to actions from the BoJ, but due to delayed rate cut anticipations from the Fed which maintained relative high spreads,” Weller added. “For bulls, 158 is the next significant target, and breaching it will prompt another challenge at the 160 mark.”

A fundamental driver of the yen's weakness is the shifting landscape of expectations surrounding US rate cuts. Following the volatile swings in rate cut projections this year, prevailing consensus holds that US inflation is unlikely to plummet, leading the Fed to postpone any potential cuts to ensure inflation doesn't resurge.

As of last Thursday, the dollar index found itself on a rebound trajectory, closing in on the 105 mark after three consecutive days of upswing. The latest Fed meeting notes reiterated that inflation was not receding as rapidly as anticipated, necessitating that policy rates remain elevated for an extended duration, while some participants indicated an appetite for further tightening. Consequently, projections for rate cuts have significantly reassessed downward.

This memo exceeded market expectations. The dollar saw a resurgence, consequently dulling commodities. Gold prices fell nearly 2% overnight, silver dipped nearly 4%, and copper tumbled by 5%. A broad swath of non-dollar currencies, including both the yen and the yuan, suffered declines.

The dynamics in the US labor market reveal a decline in initial claims for unemployment benefits by 8,000 to a level not seen since last September, signaling some relief in the employment sector. Traders are now gearing up for the impending release of the Personal Consumption Expenditures (PCE) price index, a favorably observed metric by the Federal Reserve.

Institutional opinions lean toward the view that April’s single dive in CPI does not furnish enough justification for a rate cut, with many forecasting that the Fed will require 2-3 months of satisfactory economic data before contemplating action. Consequently, many anticipate the first rate cuts occurring in September rather than June, with predictions for total cuts restrained to just one for the year.

Arend Kapteyn, UBS's Global Chief Economist, conveyed concerns regarding the PCE inflation metric, underscoring the significant weight of rental costs within this index, thus demanding attention rather than dismissing it lightly. He indicated that cooling segments of the labor market, coupled with a slight uptick in the unemployment rate, could alleviate lingering inflationary pressures, suggesting the US economy is headed towards a ‘soft’ landing. By autumn, robust evidence of economic slowing and inflation improvements might surface, potentially supporting rate cuts.

However, he also noted risks such as a failure to cool the economy or core inflation persisting near the 3% threshold. A resurgence in the unemployment rate could become an obstacle to rate cuts, signaling the Fed might contemplate reinstating hikes in 2025, which would inhibit potential economic stagnation.

The yuan's recent performance reflects a similar trajectory of weakness as the yen. Analysts emphasize the growing interconnectedness between the two currencies. On May 24, the yuan's central parity rate printed 7.1102, marking a four-month low. Liu Yang, a foreign exchange expert and head of financial market operations at Zheshang Zhongtuo Group, pointed out that the yuan's interaction with the yen has attracted increasing institutional attention. The yuan, now regarded as a low-interest currency alongside the yen, has led to a paradigm shift where it’s often utilized as a funding currency for borrowing to invest in higher-yielding assets in dollars.

Yang highlighted this evolution, stating, “Given the shift in interest rate trends, the yuan’s role in carry trades has transformed, gaining traction as a financing currency.” The enduring low-interest rate policies in Japan have established the yen as a longstanding funding currency in carry trades, thus linking these trends with the evolving yuan dynamics.

Future expectations suggest that the People’s Bank of China will strive to maintain abundant liquidity, potentially initiating another reserve requirement ratio cut or employing other liquidity tools such as MLF. UBS also indicates that if existing policy measures fall short, the government may roll out additional strategies soon.