Morgan Stanley is bullish on the yen against the trend: If the Fed continues to cut rates, it could rise to the 140 level in the coming months.

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Morgan Stanley strategists predict that as signs of a U.S. economic slowdown become increasingly apparent, if the Federal Reserve implements consecutive interest rate cuts in this context, the yen may appreciate by nearly 10% against the U.S. dollar in the coming months.

The firm pointed out that the current USD/JPY exchange rate has deviated from fair value. If this relationship is restored, with falling U.S. Treasury yields pulling down fair value, the USD/JPY is expected to decline in the first quarter of 2026. Accordingly, Morgan Stanley expects this currency pair to fall to around the 140 level early next year.

This bullish call stands in sharp contrast to the yen's recent weakness. Due to concerns that Japanese Prime Minister Sanae Takaichi’s spending plans could worsen fiscal conditions, and the market’s diminished expectations for a near-term rate hike by the Bank of Japan, the yen has fallen 5.6% this quarter, making it the worst-performing currency among the G10 currencies. As of 11:51 am Tokyo time, the yen was trading at 156.67 per dollar.

However, Morgan Stanley believes that while Japan's domestic fiscal policy environment is not particularly expansionary, external factors will dominate exchange rate movements. The firm also warned that as the U.S. economy recovers later next year and carry trade demand is revitalized, the yen will face a new round of downward pressure.

Fair Value Restoration, USD/JPY to Rebound

Morgan Stanley strategists, including Matthew Hornbach, pointed out in a report on Sunday that the current USD/JPY pricing deviates from fundamentals. The core logic behind this judgment is the downward trend of U.S. Treasury yields, which is expected to drive the exchange rate back toward fair value.

According to the firm’s specific forecasts, the USD/JPY will fall to around 140 in the first quarter of 2026. However, this appreciation trend may only be temporary. The strategists expect that as the U.S. economy recovers, carry trade demand will be reactivated, bringing renewed downward pressure on the yen in the second half of next year. The bank expects USD/JPY to rebound to around 147 by the end of 2026.

Authorities Highly Attentive and Intervention Risk

With the yen exchanging near 157 per dollar, market investors are closely assessing the risk of official market intervention. Japan's Finance Minister Kaori Katayama and other officials have recently expressed concerns over yen weakness. Katayama specifically mentioned that intervention is one of the options, although her remarks currently have limited practical impact on the market.

Meanwhile, Japanese Minister for Economic Revitalization Minoru Kiuchi said earlier on Tuesday that the government is closely monitoring exchange rate fluctuations, including speculative behavior, with a strong sense of urgency. This further highlights the Japanese authorities' cautious attitude toward current exchange rate volatility.

Recommendation to Go Long 10-Year Japanese Government Bonds

In terms of interest rate strategy, Morgan Stanley anticipates that the Japanese sovereign yield curve will show a "bullish steepening" pattern in the first quarter of 2026. This trend will mainly be driven by a slowdown in the U.S. economy and easing concerns about fiscal conditions in Japan.

Based on this assessment, the firm maintains its specific investment recommendations for the Japanese government bond market, including: recommending a long position in 10-year Japanese government bonds (JGBs), carrying out yield curve steepening trades between the 10-year and 30-year JGBs, and holding a short position on the 30-year JGB asset swap spread in the short term.

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