Risk aversion fuels safe-haven demand, sending Japanese Yen sharply higher

• Safe-haven flows into the Japanese Yen push USD/JPY lower as risk appetite weakens.
• Lower US Treasury yields offer additional support to the Yen by narrowing the US-Japan yield differential.
• Ahead of next week's Fed and BoJ decisions, traders expect both central banks to raise rates further.

A decline of nearly 0.65% on Thursday puts USD/JPY on course for its largest daily fall in a month. Mounting unease about AI-related investments is weighing on global shares and weakening risk appetite, renewing demand for the safe-haven Japanese Yen (JPY), which is outperforming all its major peers. The pair is trading at around 157 at the time of writing, its lowest since 30 September.

Although the US Dollar (USD) has staged a modest recovery, the Yen has continued to regain ground. Traders appear to prefer the Yen to the Greenback as the US remains at the heart of the AI investment boom. Having touched a three-week low of 101.45, the US Dollar Index (DXY), a measure of the Greenback against a basket of six major currencies, is trading at around 101.75.

Demand for government bonds has also increased as investors retreat from risk, sending yields lower across major economies. This has narrowed the US-Japan yield differential, lending the Yen additional support. At around 5.04%, the benchmark 10-year US Treasury yield is down 1% on the day, while Japan's 10-year government bond yield is near 2.86%, a daily decline of 0.50%.

Further Yen gains may nevertheless be constrained by the still-wide US-Japan yield differential and persistent concerns about Japan's heavy debt burden. Nor may the Bank of Japan's (BoJ) gradual tightening materially reduce the interest rate gap with other major economies: central banks continue to take a hawkish stance as the Middle East conflict raises energy-driven inflation risks.

An unchanged policy rate at the Bank of Japan's late-October meeting is the expectation of analysts at Standard Chartered, who say, “We expect the Bank of Japan (BoJ) to keep the policy rate unchanged at 1.25% at its 29-30 October meeting, following September’s 25bps hike.” They nonetheless expect officials to “maintain a clearly hawkish tone,” observing that “the debate is increasingly shifting from whether the BoJ will hike again to when the next hike will occur.” Although December is now viewed as “a live meeting,”

Standard Chartered stresses that “January 2027 remains our base case for the next hike.” In the bank's view, the BoJ also has reason to pursue gradual normalisation, arguing that “the BoJ has an incentive to continue policy normalisation to support yield differentials and reduce the risk of renewed JPY weakness, particularly if the Fed resumes tightening or maintains a restrictive policy stance for longer than expected.”

Following September's increase of 25 basis points (bps), the Federal Reserve (Fed) is likewise widely expected to hold US interest rates steady next week. Policymakers remain focused on returning inflation to the 2% target, however, and traders have almost fully priced in a further increase in December. The CME FedWatch Tool puts the probability at around 89%.