Synopsis:

Goldman Sachs discusses their outlook for USD/JPY, emphasizing the role of US rates and real rate differentials in determining the pair's future performance.

Key Points:

1. Dominance of US Rates:

   • Return to Fundamentals: Goldman Sachs expects USD/JPY to align more closely with fundamentals, particularly US interest rates, following recent dislocations driven by carry trade unwinds.
   • Constructive US Outlook: With a more optimistic baseline for the US economy, Goldman anticipates a gradual upward trend in USD/JPY, supported by their forecasts for higher equities and a weaker Chinese yuan (CNY).

2. Risk of US Recession:

   • Downside Scenario: Goldman notes that if the US were to enter a recession, their rates strategists predict nominal rates could fall to 3.5-3.75%. In such a scenario, their FX model suggests a potential 5% decline in USD/JPY, with the impact likely to double when factoring in weaker equities and further carry trade unwinds.

3. Real Rate Differentials:

   • Increased Correlation: Goldman expects USD/JPY to become more correlated with real rate differentials moving forward, although they remain cautious about the consistency of this relationship given the recent periods of dislocation.
   • Upside Pressure: Assuming the US avoids recession and carry trades remain attractive (despite expected additional BoJ hikes), Goldman anticipates renewed upside pressure on USD/JPY.

Conclusion:

Goldman Sachs remains cautiously optimistic about the outlook for USD/JPY, expecting it to gradually rise if the US economy remains strong and real rate differentials drive the cross higher. However, they acknowledge significant downside risks in the event of a US recession.