After Trump's re-election, there has been a divergence in policy expectations between the Federal Reserve and the Bank of Japan. As the Federal Reserve's interest rate cut bets decrease, the US dollar is bullish. Will those who are bearish on the Japanese yen regain their dominant position in 2025?

The 'Trump deal' strengthens dollar bulls

The Federal Reserve cut interest rates in September last year, but instead of falling, the US dollar began a new round of rise as policymakers shattered people's hopes of actively relaxing policies. With the arrival of 2025, the advantage of the US dollar is undeniable. The US dollar will not only be supported by a resilient US economy and sustained price pressures, but also by expectations that the incoming Trump administration will enact further policies to boost economic growth and inflation.

(The US dollar index and the yield of US 10-year treasury bond bonds rebounded strongly in autumn due to the soaring yield.)

Trump's historic victory in the 2024 presidential election will be the decisive narrative for the financial markets of 2025. However, while assets such as the US dollar and stocks are cheering for the prospect of Republican control of Congress, not everyone is celebrating Trump's return to the White House.

Setting aside the risks of countries potentially benefiting from Trump's trade rhetoric, his campaign promises are believed to lead to inflation, which could be a headache for the Federal Reserve. The expectation that substantial tax cuts and tariff increases will exacerbate inflation has pushed the yield of US treasury bond bonds to their highest level in several months, pushing the US dollar higher.

How much inflation will Trump's policies cause?

The question for the 2025 outlook is how quickly the Republican Party can push their tax agenda, and how easily Trump will resort to imposing higher tariffs when starting trade negotiations with major US trading partners such as the European Union and Mexico?

But it's not just a matter of timing. Since the budget deficit is more than 6% of GDP and the treasury bond is expanding, Republicans can cut spending to pay for their tax incentives and offset some tax cuts to boost the economy.

In terms of tariffs, it is still unclear to what extent the new Trump administration will impose higher tariffs on imported goods, and Trump tends to use sensationalism as a negotiation strategy.

Despite the strong economy, the debt burden of the US government is too high

Therefore, for the US dollar, the key is how much has been digested and how much has not yet been digested by investors. Any indication that Trump's campaign promises have been downplayed could have a negative impact on the US dollar in 2025. Similarly, if newly elected lawmakers delay in preparing and agreeing to Trump's legislative agenda, the US dollar is likely to rebound.

However, if Republicans quickly take tax cuts and Trump shows an unwillingness to compromise on trade issues, the US dollar is likely to climb to the high point of the Federal Reserve's massive interest rate hike in 2022.

The Federal Reserve's Inflation Dilemma

Although the days of tightening policy by the Federal Reserve have come to an end and borrowing costs are decreasing, the battle against inflation has not been won, and policymakers are cautious about cutting interest rates too quickly. The unexpectedly tough stance of the Federal Reserve highlights the bullish outlook for the US dollar. People's main concern is that the inflation rate seems to be approaching 2.5% instead of the Federal Reserve's target of 2.0%.

(CBOT 30 Day Federal Fund Futures Implied Yield Curve)

If this situation occurs before Trump takes office, the Federal Reserve will not be able to cut interest rates multiple times in 2025, and the possibility of rate hikes cannot be completely ruled out.

Geopolitical risks

Leaving aside domestic politics and Federal Reserve policies, inflation risk tends to rise to some extent. Trump's election as president may push for a ceasefire agreement between Ukraine and Russia, however, Trump may take a tougher stance on Iran. This could potentially trigger broader conflicts in the Middle East, especially if it involves imposing stricter sanctions on Iranian oil or allowing Israel to attack Iran's oil facilities.

While the Federal Reserve is still working to curb inflation, a new oil price shock is not what it needs. As the world's reserve currency, the US dollar will also directly benefit from safe haven sentiment.

Will the inflation level in the United States, which has not yet reached the 2% inflation target, pause in 2025

In summary, although there are currently not many factors that can trigger a large-scale sell-off of the US dollar, the ability of the dollar to continue to rise depends on the actual scale of the tax cuts and tariff increases that Trump will ultimately approve.

The roller coaster journey in Japanese yen

So, what does all of this mean for the Japanese yen? This summer, the Japanese yen exchange rate has rebounded significantly from its 1986 level. The policy adjustments of the Bank of Japan and the Federal Reserve, as well as the direct intervention of Japanese officials in the foreign exchange market, have jointly driven the bullish reversal of the yen.

(The Japanese yen has gone through a roller coaster year)

However, the Bank of Japan's unexpectedly tough stance quickly turned cautious, and uncertainty about the subsequent pace of interest rate hikes has been putting pressure on the yen. But this does not mean that the yen cannot restore its bullish trend in 2025.

The Bank of Japan only focuses on wages

Although Japan's inflation rate has dropped to around 2.0%, policy makers believe that wage pressures, yen depreciation, and rising commodity prices leading to increased import costs will pose upward risks to the economic outlook. The Bank of Japan hopes that next spring's wage negotiations will lead to another strong pay agreement.

The largest union in the country hopes for a wage increase of at least 5.0%. This result may pave the way for the Bank of Japan to raise interest rates to 1.0% by the end of 2025.

Will the central bank continue to raise interest rates when Japan's inflation and wage levels are at decades high levels

The difference in yield is very important

However, even if borrowing costs rise to 1.0% or higher, if the Federal Reserve finds itself with very limited room to cut interest rates, the yield gap with the United States may not necessarily narrow much. Therefore, although the determination of the Bank of Japan to normalize monetary policy may catch some investors off guard, any rebound in the yen will depend on the policies of the Federal Reserve and domestic policies.

However, due to the escalating geopolitical tensions and Trump's return to the White House, the global economic outlook is shrouded in uncertainty, and safe haven funds may also become a savior for the yen in 2025.