Yen Faces Steep Fall if Japanese Stocks Plummet

A substantial downturn in Japanese equities could precipitate a sharp depreciation of the USD/JPY currency pair, as per Citi strategists. The yen's recent weakness has been exacerbated by significant inflows into Japanese stocks and associated currency hedging activities by both domestic and international investors.

While the Nikkei 225 has experienced a correction from its peak, the broader TOPIX index continues to trade at elevated levels near 4,000. Strategists indicate that this current market adjustment is unlikely to spur significant yen appreciation as long as the TOPIX remains close to its present valuation.

Historically, since 2024, the yen has shown a tendency to strengthen more rapidly when the TOPIX declines by over 10%. If the index were to fall to approximately 3,600, representing a 10% decrease from current levels, USD/JPY could experience a steep decline. Such a scenario might prompt foreign investors to reduce currency hedges or liquidate equity-related positions.

The interplay between Japanese equities and USD/JPY is intricate, with a weaker yen potentially benefiting exporters by increasing the value of their foreign earnings. Conversely, rising stock markets can generate transactions that exert downward pressure on the currency.

However, the sensitivity of USD/JPY to Japanese stocks has diminished since 2025, partly due to a narrowing monetary policy gap between the U.S. and Japan. This shift has provided underlying support for the yen, limiting the currency's reaction to increases in Japanese share prices.

Based on the TOPIX-USD/JPY relationship observed since 2025, the currency pair's implied level is around 160. Applying a stronger correlation from the 2012-2024 period suggests an estimate closer to 175. Despite this, a steep TOPIX correction is not the base case scenario, as the outlook for Japanese equity strategy remains bullish, potentially keeping USD/JPY elevated while reduced sensitivity may cap further yen depreciation.