Currency analysts at MUFG note that monetary policy divergence will continue to undermine the yen when interest rates rise outside Japan, while the Bank of Japan maintains a very loose monetary policy.

However, tightening global risk conditions will provide an element of protection for the yen, and countering the weakening of the yen in Japan is likely to gain momentum.

According to MUFG, the dollar/yen exchange rate (USD/JPY) is near a key long-term level; “yen weakening is likely to accelerate further if USD/JPY breaks above 135.15”.

USD/JPY traded around 134.20 on Friday after the US CPI data, with stocks on Wall Street declining sharply.

Global policy divergence undermines the yen

The Japanese yen has weakened this month, suffering losses across the board. The USD/JPY pair hit a 20-year high just above 134.50 before a limited correction to 134.00.

Euro to yen (EUR/JPY) also hit seven-year highs above 144.00 before retreating.

MUFG notes that the Japanese currency has been undermined by trends in global monetary policy. It notes: “Over the past couple of weeks, the yen has been hit hard by both continued central bank hawkishness outside Japan and rising energy prices, which are further undermining Japan’s terms of trade.”

MUFG notes that the Federal Reserve has muted speculation that the Fed may authorize a pause in rate hikes after its July meeting.

The latest U.S. inflation data came in stronger than expected, with the core annualized rate rising to 8.6% from 8.3%, which will keep pressure on the Fed to tighten more aggressively.

The US 10-year rate yield is above 3.00%, while Germany’s 10-year yield hit an 8-year high near 1.40%.

The ECB is also set to raise interest rates at its July and September meetings.

The Australian and Canadian central banks have also announced further rate hikes this month.

In contrast, the Bank of Japan reiterated its determination to pursue a very expansionary policy with negative interest rates and a cap on 10-year bond yields at 0.25%.

MUFG noted, “Recent hawkish policy signals have reinforced market expectations of widening policy divergence between the Bank of Japan and other major central banks.”

Risk appetite is down, equity markets are in focus

The yen, however, will get an element of protection in the event of a sharp fall in equity markets.

Wall Street stocks reacted unfavorably to the latest U.S. inflation data, and tightening global financial conditions will also defend the Japanese currency.

MUFG also notes that the Japanese population is sensitive to a weaker yen and will be under pressure to limit appreciation ahead of the upper house elections in July.