Why is the Japanese Yen surging as risk-off sentiment fuels safe-haven demand?

• Safe-haven buying lifts the Japanese Yen and pushes USD/JPY lower as risk appetite weakens.
• The Yen receives additional support as lower US Treasury yields reduce the US-Japan yield differential.
• Ahead of next week's Fed and BoJ policy decisions, traders expect both central banks to raise rates further.

Risk appetite is weakening as mounting worries about AI-related investments drag global equities lower, prompting fresh safe-haven buying of the Japanese Yen (JPY), which is strengthening across the board. Against this backdrop, USD/JPY is down nearly 0.65% on Thursday and heading for its steepest daily fall in a month. The pair is trading near 157 at the time of writing, its weakest level since 30 September.

A modest recovery in the US Dollar (USD) has not prevented the Yen from rebounding. Traders appear to prefer the Japanese currency to the Greenback, with the US at the centre of the AI investment boom. After touching a three-week low of 101.45, the US Dollar Index (DXY), which measures the Greenback against a basket of six major currencies, is trading near 101.75.

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

Further gains in the Yen may nevertheless be constrained by the still-wide US-Japan yield differential and persistent worries about Japan's heavy debt burden. The Bank of Japan's (BoJ) gradual policy tightening may also have little impact on its interest rate gap with other major economies. Central banks remain hawkish as the Middle East conflict creates energy-driven inflation risks.

An unchanged policy rate is the expectation of Standard Chartered analysts for the Bank of Japan's late-October meeting: “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 considered “a live meeting,”

Standard Chartered stresses that “January 2027 remains our base case for the next hike.” In the bank's view, the BoJ 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 25 basis points (bps) increase, the Federal Reserve (Fed) is widely expected to hold US interest rates steady next week as well. 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 of that move at around 89%.