The key to reversing the weakening JPY trend is entering a truly "defensive" macro environment

Overview

This report discusses what conditions could reverse the weakening yen trend. Morgan Stanley points out that since Middle East tensions escalated in late February, JPY has still underperformed among G10 currencies despite a temporary deterioration in global risk sentiment. The core explanation is that rising oil prices and expectations of an effective closure of the Strait of Hormuz have worsened Japan's terms of trade, putting pressure on the currency of an energy-importing country.

Core views

The core view of the report is that for JPY to stage a meaningful and sustainable rebound, the market needs to shift from a carry-like regime dominated by inflation concerns to a Defense Regime dominated by growth concerns. In the current context, this means oil prices staying high long enough to cause demand destruction, growth risks outweighing inflation risks, and central bank policy expectations shifting toward rate cuts. At this stage, because the market still sees Middle East tensions as likely to ease and US data remain resilient, the report does not yet treat this as the base case, but believes the longer the effective closure of the Strait of Hormuz lasts, the greater the risk.

Analysis framework

The report explains why JPY has still not clearly outperformed during the risk-off phase by analyzing daily G10 currency performance against the dollar, principal component analysis, the relationship between oil prices and risk sentiment, the relative performance of energy-importing versus energy-exporting currencies, and a USD/JPY fair value model that incorporates US terminal rate expectations, global risk sentiment, and Japan's terms of trade.

Methodology notes

• FX factor decompositionPrincipal Component Analysis (PCA)

  Uses PC1 and PC2 to explain the common driving factors behind G10 currency moves against the US dollar.

  The report compares the changes in PC2 characteristics before and after the escalation of Middle East tensions, arguing that PC2 became less linked to global risk sentiment and temporarily more linked to oil prices, indicating that energy prices and terms of trade had become new FX drivers.

• Macro scenario frameworkUSD Regimes Framework

  Distinguishes USD trading environments through the combination of US real yields and inflation breakevens.

  The report argues that JPY is more likely to perform well in a Defense Regime, namely a global risk-off environment in which US real yields and inflation breakevens both fall and the market prices in aggressive Fed easing.

• Valuation modelUSD/JPY fair value model

  Explains USD/JPY using US terminal rate pricing, global risk sentiment, and Japan's terms of trade.

  The report says that after incorporating Japan's terms of trade into the model, it can better explain the recent JPY weakness against the dollar, because rising energy prices constrain Japan as an energy-importing economy.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• JPY (Japanese yen)

  Core asset of the report

  Strengths

  In a true global risk-off environment and Defense Regime, JPY may benefit from safe-haven demand and Fed rate-cut pricing.

  Weaknesses

  Japan is highly dependent on energy imports, and rising oil prices worsen its terms of trade, making it difficult for JPY to display its traditional safe-haven characteristics in a stagflationary environment.

  Comparison

  Compared with currencies of economies such as AUD, NOK, CAD, and USD, which are energy exporters or less dependent on energy imports, JPY has recently been weaker; it is also under pressure together with currencies of energy-importing countries such as EUR, NZD, SEK, CHF, and GBP.

  Risks

  If Middle East tensions ease, US data remain resilient, or the BoJ adopts a dovish tone, a JPY rebound may be delayed.

• USD/JPY

  Main trading expression

  Strengths

  With resilient US data and expectations of easing Middle East tensions, USD/JPY may still remain near the upper end of its range in the short term.

  Weaknesses

  Stronger verbal intervention by Japan's Ministry of Finance, a longer effective closure of the Strait of Hormuz, and growth concerns outweighing inflation concerns would all limit USD/JPY upside and increase downside risk.

  Comparison

  The report believes the current environment has not fully shifted into a Defense Regime, but the risk-reward in USD/JPY has already begun to tilt downward again.

  Risks

  If the market reprices toward fewer Fed rate cuts or the oil-price shock continues to be reflected mainly as an inflation risk, USD/JPY downside may be limited.

Key data

• Report date2026-04-23The date matches the filename and report content.
• Key FX assetsUSD/JPY, JPYThe report focuses on the relative performance of the yen within G10 FX and the directional risk in USD/JPY.
• Starting point of key observation2026-02-27In multiple sections, the report uses the escalation of Middle East tensions after February 27 as the dividing line for currency performance and PCA analysis.
• Key technical level / intervention backdropUSD/JPY approaching 160The report mentions that when USD/JPY approached 160 in mid-January, the US Treasury conducted a rate check through the Fed, meaning the market could not rule out the risk of coordinated intervention.
• PC2 relationship with oil pricesR² approximately 0.2272The chart shows that the regression fit between PC2 and related variables is limited but exhibits periodic correlation, supporting the explanatory role of oil prices in FX factors.

Impact & implications

For FX investors, the report implies that it is unwise to simply go long JPY just because risk appetite declines; more important is determining whether the oil shock is an inflation shock or a growth shock. If the market remains worried about inflation and reduces Fed rate-cut pricing, JPY may continue to be dragged down by terms of trade; if high oil prices cause demand destruction and push rate-cut pricing higher, JPY's safe-haven characteristics are more likely to regain the upper hand, and the opportunity for USD/JPY downside will become clearer.

Risks

• If Middle East tensions cool quickly, pressure from oil prices and terms of trade may ease, weakening the trigger conditions for a JPY rebound.
• If US macro data continue to show resilience, the market may not price in sufficiently aggressive Fed rate cuts, making a Defense Regime difficult to form.
• If BoJ Governor Ueda emphasizes downside growth risks more than potential upside inflation risks at the press conference, the initial market reaction may be negative for JPY.
• If the oil shock is interpreted by the market mainly as an inflation risk rather than demand destruction, JPY may continue to be dragged down by the stagflation narrative.
• The risk of intervention by Japan's Ministry of Finance and potential coordinated intervention may limit USD/JPY upside, but the timing and magnitude of intervention itself remain uncertain.

What to watch

• Whether the effective closure of the Strait of Hormuz persists, and whether it evolves from a supply shock into demand destruction.
• Oil price trends and their impact on Japan's terms of trade.
• Whether US real yields, inflation breakevens, and Fed rate-cut pricing all move lower together.
• How the BoJ's April meeting and Governor Ueda's press conference balance growth risks against inflation risks.
• The intensity of verbal intervention by Japan's Ministry of Finance regarding the FX market, as well as signals of FX policy coordination between the US and Japan.
• Whether the relative performance gap between energy-importing and energy-exporting currencies within G10 continues to widen.