Synopsis:

Société Générale assesses the potential for a final significant surge in USD/JPY, following the Bank of Japan's decision to maintain interest rates and adjust inflation forecasts upward. The analysis focuses on the impact of diverging yield dynamics between the U.S. and Japan and the fundamental valuation of the yen.

Key Points:

• Bank of Japan’s Policy Decision: As expected, the Bank of Japan held interest rates steady at its recent policy meeting but raised its inflation forecasts for the fiscal year 2025/26, anticipating core inflation at 2.1% and real GDP growth at 1%.

• Yield Differentials: The ongoing disparity between U.S. and Japanese yields, with U.S. yields on the rise and Japanese yields constrained by low short-term rates, continues to fuel the ascent of USD/JPY. This yield differential, historically aligned with more than nominal GDP growth over time, suggests potential narrowing in the future but remains wide for now.

• Long-Term Valuation of the Yen: According to SocGen, the yen is fundamentally undervalued, with purchasing power parity (PPP) for USD/JPY estimated in the mid-90s, while a fair value adjusted for U.S. exceptionalism and Japanification would be around 110. The current levels are significantly above these estimates due to the large yield gap.

• Potential for a Final Surge: There is a concern that unless Japanese policymakers adopt more aggressive measures, both in terms of intervention and monetary policy adjustments, the continued upward pressure on USD/JPY could lead to an excessive final spike before the eventual normalization.

Conclusion:

SocGen's analysis indicates that while a correction in USD/JPY is inevitable due to fundamental undervaluation and expected shifts in yield differentials, the timing and nature of this adjustment could be dramatic unless there is significant policy action from Japan. The firm suggests that market participants should prepare for potential volatility in USD/JPY, especially as U.S. yields continue to climb and Japanese rates remain low.