As the financial year 2024 approaches its conclusion, the performance of the US dollar and American stock markets stands out as particularly strong, casting a shadow over other major marketsThis disparity arises despite central banks adopting differing monetary policies, which have not hindered market dynamics driven by expectations of economic trends and policy shiftsA stark contrast is evident when examining the Federal Reserve and the Bank of JapanThe former has implemented three interest rate cuts this year, cumulatively lowering rates by 100 basis points to a target range of 4.25% to 4.5%. Conversely, the latter has made unprecedented moves by raising rates two times, now settling at 0.25%.

As previously noted, despite the diverging paths of these two central banks, the strength of the US economy and its elevated interest rates continue to overshadow Japanese assetsWith the Fed's rate cuts, the currency-hedged bond yields for Japanese investors have surpassed zero for the first time in over two years

Specifically, the yield on 10-year US Treasury bonds, adjusted for currency risk, has now reached 0.28%, breaking a pattern of remaining below zero since September 2022. As the Fed shifts towards a more accommodative stance while the Bank of Japan raises borrowing costs, the cost of hedging has declined by roughly 170 basis points from a peak in October 2023.

The inflow of Japanese funds into the US bond market seems poised to continue through 2025. Traders remain skeptical about the pace at which the yield differential between the two markets will close, resulting in a reduction of bets on a rising yenThis pattern comes against the backdrop of data compiled by Bloomberg, indicating that in the first ten months of this year, Japan's net purchases of US bonds have reached an impressive 15.1 trillion yen (approximately $960 billion). Last year, from January to October, Japan's net purchases hit a record-breaking 20 trillion yen

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In contrast, the Japanese yen has depreciated by about 7% against the US dollar during this same period.

Given that US yields are hovering above 4%, the declining value of the dollar against the yen presents an enticing opportunity for investors looking to capitalize on both debt capital returns and currency gainsDespite the Japanese stock market not outperforming its US counterpart this year, the benchmark Tokyo Stock Exchange index has consistently reached historical highs in 2024, posting a cumulative increase of approximately 15%. However, this growth has significantly eroded for dollar-denominated investors, with Bloomberg’s data showing a mere 3% increase in dollar terms due to a 10% depreciation of the yen against the dollarThis underperformance pales in comparison to global peers such as the Standard & Poor’s 500 index, which has surged over 25%.

Although the yen’s depreciation has boosted profits for exporters and the Bank of Japan's rate hikes have supported financial stocks, the limited net capital inflow this year indicates that the weakness and volatility of the yen are deterring foreign investments

The rising costs for imports and increased inflationary pressures stemming from a weaker yen are placing additional strain on the Japanese economyGoldman Sachs believes the current yen-to-dollar exchange rate offers a favorable climate for overseas investors looking to acquire Japanese equitiesThey anticipate limited risks of the yen depreciating further against the dollar, particularly regarding potential interventions from Japanese authorities should the yen drop below 160.

This presents a golden opportunity for foreign funds to purchase stocks at relatively low prices, with the added benefit of a decreasing likelihood of currency depreciation from yen weakness in the futureShould the yen appreciate, there would also be avenues for foreign funds to profit from foreign exchange gainsPredictions suggest that the performance of banks and other financial companies is likely to be robust in 2025, especially in light of stock buybacks, the unwinding of cross-shareholdings, and interest rate hikes.

Despite the fact that the Japanese stock market has recovered much of its value since a sharp decline in August, many foreign funds maintain a cautious stance

The downturn in August has left a lasting impression on overseas investors, fostering lingering doubts about the stability of the Japanese market even as it reboundedIn contrast, the resilience shown by the US market, particularly in the face of political uncertainties, tends to strengthen the inclination of foreign investors to keep their capital engaged in relatively stable US marketsThis tendency diminishes the motivation to reinvest in Japan’s market.

However, if investment flows return, they could provide a much-needed boost to the Tokyo Stock Exchange index, potentially helping it reclaim historical highs in 2025. Goldman Sachs has set a 12-month target for the Tokyo index at 3,100 points, in stark contrast to the index's closing price of 2,726.74 points on Monday, showcasing significant growth potentialSimilarly, UBS Securities Japan predicts a target of 2,900 points while JPMorgan anticipates 3,000 points