On August 28, Citibank's Osamu Takashima and his team released a report stating that there is still downside risk for the USD/JPY exchange rate, and investors can refer to the situations in 1995 and 1998.
In 1998, the Japanese financial crisis led to a rapid unwinding of yen carry trades, with the USD/JPY exchange rate peaking slightly above 147 in August and falling below 110 by January 1999. In August this year, after dropping to a low of 142, the USD/JPY exchange rate stopped falling but appeared weak in its recovery towards the 350-day moving average (currently around 148). Citibank believes that this lack of momentum implies that if a financial shock similar to the LTCM crisis occurs, there may be further risk of a collapse in the USD/JPY exchange rate.
In 1995, the Washington G7 meeting marked a turning point for the yen's appreciation, and the current situation is at a turning point from yen depreciation to yen appreciation.
<h2>Referencing 1998: Market Expectations of Narrowing US-Japan Interest Rate Spread</h2>
The USD/JPY exchange rate has been rising since 2021, breaking above 161 in July and then rapidly declining.
Historically, when the US-Japan interest rate spread exceeds 4.75%, the USD/JPY exchange rate shows a clear upward trend, and when the spread is below 4.75%, the rate shows a clear downward trend. When the spread is between 4.25% and 4.75%, the USD/JPY exchange rate tends to decline, mainly due to unwinding of yen carry trades.
Currently, the Federal Reserve's interest rate is 5.33%, Japan's short-term rate is 0.25%, and the US-Japan interest rate spread is 5.08%. Citibank believes that the decline in the USD/JPY exchange rate since July reflects the market's expectation of a narrowing US-Japan interest rate spread.
However, the US-Japan interest rate spread is still significant, with the USD/JPY exchange rate around 145. Therefore, Citibank believes that the temporary recovery of yen carry trades is normal, and the USD/JPY exchange rate will not fall below 140 in the short term.
Nevertheless, Citibank still believes that the subsequent narrowing of the US-Japan interest rate spread and the resulting valuation adjustment will continue to weigh on the USD/JPY exchange rate.
When the US-Japan interest rate spread exceeds 5%, the USD/JPY exchange rate shows a clear upward trend in one month and three months, and when the spread is below 0%, it shows a clear downward trend. However, when the spread is between 5% and 0%, the rate performance is often neutral. This is not because the USD/JPY exchange rate is not volatile, but because the rise during spread expansion is offset by the fall during spread contraction, resulting in an overall neutral performance
Citigroup pointed out that since 2022, during the period of widening short-term interest rate differentials between the US and Japan, the USD/JPY exchange rate has fluctuated between around 140 (when the interest rate differential is 3%) and 130 (when the interest rate differential is 2%).
At the same time, Citigroup's economic team predicts that the Federal Reserve will cut interest rates to around 3% in the next year, while the Bank of Japan will raise rates to 0.75%, resulting in a US-Japan interest rate differential of 2.25%. As mentioned earlier, when the interest rate differential is below 4.75%, there will be a clear downward trend in the USD/JPY exchange rate.
Based on this, Citigroup roughly estimates that the equilibrium point of the USD/JPY exchange rate should be about 10 lower than the current rate, indicating a further decline in the USD against the JPY. Citigroup forecasts that the USD/JPY exchange rate will be 137 by September next year, and a range of 125-135 for the exchange rate is also considered normal.
<h2>Reference to 1995: Currently at the turning point from JPY depreciation to JPY appreciation</h2>
Given the JPY carry trade, Citigroup is bearish on the USD/JPY exchange rate for the next few years in the medium to long term, and in the ultra-long term, Citigroup supports the view of structural weakness in the JPY, believing that the USD/JPY exchange rate will also decline. From this perspective, the long-term appreciation of the JPY from the 1980s to 1995 led to deflation in the Japanese economy, but at the same time, the long-term depreciation of the JPY from the 2010s to the present has ended the lagging effect of JPY appreciation and produced a lagging effect of JPY depreciation.
The chart below compares the depreciation of the JPY since the 2010s with the appreciation of the JPY since the 1980s. The chart shows that we are currently at a turning point from JPY depreciation to JPY appreciation, which is roughly the same time as the 1995 Washington G7 meeting marked the turning point of JPY appreciation. In other words, Citigroup now expects the USD/JPY exchange rate to decline not only due to the impact of JPY carry trade, but also due to the reversal of structural JPY depreciation, which has been going on for about a decade.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/d7d93e3e-2ce6-4977-961a-98f7b891e1cb.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/d7d93e3e-2ce6-4977-961a-98f7b891e1cb.png"/>
The JPY depreciation started in 1995 and lasted until the Japanese financial crisis in 1997, ultimately ending with the LTCM crisis in 1998. At that time, the USD/JPY exchange rate returned to the trading range of 120-150 in the late 1980s and early 1990s. The current situation is equivalent to returning to the trading range of 100-125 in the latter half of the 2010s

Given the yen carry trade, Citigroup is bearish on the USD/JPY exchange rate for the next few years. However, from a very long-term perspective, Citigroup supports the view of structural weakness in the yen. Currently at a turning point from yen depreciation to yen appreciation, Citigroup believes that the USD/JPY exchange rate will also decline

- Citigroup's Osamu Takashima and team suggest that the USD/JPY exchange rate faces downside risks, drawing parallels to 1995 and 1998 scenarios. In 1998, the Japanese financial crisis led to a rapid unwinding of yen carry trades, causing the rate to peak above 147 in August and drop below 110 by January 1999. Currently, the rate hovers around 145, with Citigroup anticipating a gradual decline towards 137 by September next year.
- The report highlights the historical relationship between the USD/JPY rate and the US-Japan interest rate differential, indicating a potential further decline due to expectations of a narrowing interest rate gap. Despite temporary rebounds, Citigroup foresees sustained pressure on the rate as the interest rate differential shrinks, possibly pushing it below 140 in the short term.
- Citigroup's analysis suggests a shift towards yen appreciation, supported by expectations of a US rate cut to around 3% and a Japanese rate hike to 0.75%, narrowing the interest rate gap to 2.25%. This forecast aligns with a long-term bearish view on the USD/JPY rate, estimating a balance point around 10 points lower than the current rate, with a projected range of 125-135 in the near future.

Citigroup: US-Japan interest rate spread breaks key level, will the yen repeat the dramatic surge of 1998?