Investing.com — The potential impact of the U.S. Federal Reserve’s interest rate cuts on the currency pair is a key consideration for investors and currency strategists, especially with a possible change in the Fed’s decision looming in 2024.

Given the diverging monetary policies of the Federal Reserve and the Bank of Japan (BoJ), market participants are divided on whether the Federal Reserve’s interest rate cuts will lead to a weakening of the USD/JPY pair.

BofA analysts say the relationship between the Fed’s rate cuts and the USD/JPY exchange rate is more complicated and depends on a number of structural and macroeconomic factors.

Contrary to widespread market expectations, the connection between the Federal Reserve’s interest rate cuts and the weakening of the USD/JPY pair is not obvious.

Historically, USD/JPY has not always fallen during Fed easing cycles. A key exception was the Global Financial Crisis (GFC) of 2007-08, when a reversal of the yen carry trade caused the yen to appreciate significantly.

Outside of the financial crisis, Federal Reserve interest rate cuts such as those in the 1995–96 and 2001–03 cycles have not led to a significant decline in the USD/JPY pair.

This suggests that the context of the broader economy, particularly in the US, plays a key role in how the USD/JPY pair reacts to changes in interest rates set by the Federal Reserve.

BofA analysts point to a change in capital flows in Japan that weakens the likelihood of a piercing appreciation of the JPY in response to the Fed’s interest rate cuts.

Over the past decade, Japan’s overseas assets have shifted from foreign bonds to foreign direct investment and equities.

Unlike bond investments, which are highly sensitive to interest rate differentials and the carry trade environment, FDI and equity investments are more driven by long-term growth prospects.

As a result, even if US interest rates fall, Japanese investors are unlikely to decide to repatriate funds en masse, which would limit the upward pressure on the yen.

In addition, demographic challenges in Japan have contributed to a continuing outflow of foreign direct investment that has proven largely independent of U.S. interest rates and exchange rates.

This ongoing capital outflow is structurally bearish for the yen. Retail investors in Japan have also increased their exposure to foreign stocks via mutual funds (Toshins), a trend supported by the expanded Nippon Individual Savings Account (NISA) program, which encourages long-term investments rather than short-term speculative flows.

“Without a hard landing in the US economy, the Fed’s rate cuts may not have a fundamentally positive impact on the JPY,” analysts said.

The risk of a prolonged balance sheet recession in the US remains narrow. The US economy is expected to achieve a tender landing.

In such a scenario, the USD/JPY rate is likely to remain elevated, especially since the Fed’s rate cuts are likely to be gradual and moderate given the current outlook.

The expectation of three 25bp cuts by the end of 2024, rather than the 100bp+ priced in by the market, further supports the view that USD/JPY could remain mighty despite US monetary policy easing.

Another crucial factor to consider is Japanese life insurers, which have historically been significant participants in overseas bond markets.

Although high collateral costs and a bearish outlook for the yen have prompted annuity holders to lower collateral ratios, this trend limits the yen’s upside potential if the Federal Reserve cuts interest rates.

In addition, lifetime bondholders have reduced their exposure to foreign bonds, and most Japanese investments in foreign bonds are held by public pension funds.

These pension funds are less likely to react to short-term market fluctuations, further reducing the likelihood of the yen appreciating.

While BofA remains constructive on USD/JPY, there are risks that could change the trajectory. A US recession would likely lead to a more aggressive round of Fed rate cuts, potentially pushing USD/JPY lower to 135 or lower.

However, this would require a significant deterioration in US economic data, which is not the base case for most analysts. On the other hand, if the US economy accelerates and inflationary pressures persist, USD/JPY could rise further, potentially testing 160 again in 2025.

The risks from BoJ policy changes are considered less significant. Although the BoJ is gradually normalizing its ultra-loose monetary policy, Japan’s neutral interest rate remains well below the US rate, meaning that Fed policy is likely to have a larger impact on USD/JPY than BoJ moves.

Moreover, the Japanese economy is more sensitive to changes in the US economy than vice versa, reinforcing the view that Federal Reserve policy will be the dominant factor influencing the USD/JPY exchange rate.