Will USD/JPY continue to fall ahead of Fed & BoJ policy meetings?

Welcome to the MUFG Global Markets FX Week Ahead podcast with Lee Hardman, Senior Currency Analyst at MUFG. It's Friday, 5th December 2025, and joining Lee to pose some questions on the financial market themes for the week ahead is Abdul Ahad Lockhart, Currency Analyst at MUFG. The following podcast is intended for professional investors and eligible counter parties only, and not for retail clients.

Any content should not be regarded as an offer to conduct investment business or an investment recommendation, but for information purposes only. Hi, Lee. Hi, Abdul Ahad.

So the dollar has continued to weaken ahead of next week's FOMC meeting. What do you think the impact of the Fed's policy update will be on the dollar? Yeah, like you said, we've seen the dollar correcting lower now for two consecutive weeks ahead of next week's Fed policy meeting.

Obviously, over that two-week period, we've seen the U.S. rate market move to more fully price in a 25 basis point cut for the Fed next week. So we think that the market is obviously well priced now for the Fed to cut rates next week, and that's still our kind of base case view. We think that the leadership of the Fed will still try to push through a third consecutive rate cut.

Admittedly, we are expecting there to be more opposition to a rate cut next week. We could see more dissents from other FOMC participants, but we think that the leadership's likely to at least agree some form of compromise agreement with the more hawkish participants. And I think that deal could involve cutting rates, but the trade-off being that the updated guidance going forward is likely to strike a more hawkish tone next week.

So we are expecting a hawkish cut from the Fed, and we think the message from the Fed is likely to indicate that going forward, the pace of rate cuts is likely to slow. It's very unlikely that we'll see another back-to-back rate cut at January policy meeting unless the labor market data by that point in time is particularly bad. Obviously, it's still very much data dependent, but I think the Fed would probably like to signal at least at next week's meeting that they would like to take a bit more time to assess how the economy is developing before they cut rates again next year.

So for the short-term impact, that should help to limit for the dollar downside. We may even see a bit of a relief rally for the dollar next week if the Fed does give more hawkish guidance. Okay.

So we've also seen that the yen has strengthened this week driven by expectations that the BOJ will hike rates. Do you think the yen will continue to rebound if the BOJ hikes rates? Yeah, I definitely think that's what policymakers in Japan are hoping.

As we've seen this week, the BOJ has signaled strongly that they are planning to raise rates this month. We think that's down to kind of concerns over how weak the yen has been over the last couple of months in Sanai to Kaichi when the LDP leadership election became the prime minister in Japan. It does look like the BOJ has been given the green light from the government to hike rates.

So again, that could reflect concerns as well about yen weakness from the government in Japan. So we do think they will hike rates and reports are also suggesting that they will also kind of signal at the same time that they do plan to keep raising rates next year if the economy evolves in line with our expectations. So our forecast here at MUFG is that we're looking for another two further rate hikes next year from the BOJ, kind of sticking to a more gradual pace of tightening, so a hike every six months or so in 2026.

So normally you would think with Japan raising interest rates and the Fed likely to cut rates next week and further next year, that narrowing of the yield spread between the US and Japan, that should discourage long dollar yen positions and could trigger a correction lower for dollar yen. But what we've been highlighting on this occasion is that there are also a number of other reasons which are contributing to the yen being weak at this point in time. One is the fiscal risks in Japan under the new government.

So they have put together a bigger than expected budget, and that's added to fiscal concerns amongst investors in Japan. And while those fiscal risks remain on the table, that might make it more difficult for the yen to rebound, even if the BOJ hikes rates as we expect this month. And then on top of that as well, I think the broader financial market conditions are also still quite supportive for carry trades.

Volatility going into year-end is close to year-to-date low. So even if yield spreads do narrow, volatility is low, then it's still a fairly attractive environment for putting on carry trades, which could continue to curtail upside for the yen in the near term. I know, Abdullah, as well, you've also been doing some of your own work looking into valuation for dollar yen, looking at the traditional short-term fundamental drivers.

Be interesting to hear your thoughts on how things are playing out recently. Yeah, thanks, Lee. The recent relationship between dollar yen and US-Japanese yield spreads confirm a structural shift in dollar yen dynamics.

So historically, the pair has closely tracked short-term US-Japanese rate differentials, making the two-year spread a core input in our short-term fair value model, alongside implied volatility, risk reversals, and other macro features. However, since October, our regression models have shown a persistent misvaluation between spot and the fair value. This divergence coincides with a sharp drop in correlation between dollar yen returns and US-Japan yield spreads.

So prior to October 2025, the 12-week rolling correlation with the 10-year spread averaged around 0.43, peaking at around 0.91 in February. Whereas post-October 2025, the average correlation collapsed to just below zero. So with eight consecutive negative weeks through to present.

So we interpret this as dollar yen price action reflecting Japanese-centric risk factors rather than US rate dynamics. This shift is driven by fiscal uncertainties triggered by Sanai Takaishi becoming prime minister and the bigger extra budget. So consequently, the upcoming policy decision from the BOJ and the Fed makes a less directional pull on dollar yen than in prior regimes.

So if fiscal concerns persist, the yen could remain weak, even as yield spreads continue to narrow. Thanks for that, Dilahat. Good insight.

And yeah, just thanks everyone for listening to today's podcast and have a good weekend. Thank you for listening to this MUFG Global Markets podcast. Rate, review and subscribe.

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