USD/JPY, Nikkei 225: BOJ negative rate watch shouldn’t rank highly for traders

• Focusing on what the BOJ may do with interest rates risks missing the main element driving USD/JPY higher
• The Federal Reserve interest rate outlook is very important right now. Energy prices and risk appetite are also considerations
• USD/JPY may be vulnerable to downside if Fed rate cut bets reverse. Nikkei 225 has been closely correlated with USD/JPY recently

Focusing on whether the Bank of Japan (BOJ) will scrap negative interest rates should be low on the list of priorities for USD/JPY traders to consider right now. It’s not as important as it’s portrayed to be, creating plenty of noise for an event that could pass without generating significant market volatility.

USD/JPY driven by US rate expectations

The chart below provides food for thought on what you should be focusing on as USD/JPY traders in early 2024, looking at the rolling daily correlation with US two-year yields, WTI crude oil and S&P 500 over the past month.

The relationship with US 2-year yields is extremely positive at 0.96, suggesting it’s US interest rate expectations are in the driving seat, an unsurprising outcome given USD/JPY is renowned as a play on rate differentials. Expectations for Fed rate cuts this year have been pared from over seven in January to just three today, contributing to the US yield advantage over Japan for two-year debt ballooning to over 450 basis points.  

Remember that figure when considering that now, priced into markets, there is only 33 basis points worth of rate hikes expected by the BOJ over the next two years. Unless there’s a huge shift in the BOJ’s monetary policy outlook, its side of the rate differential equation is insignificant relative to what the Fed may do.

A hike and a half relative to interest rate differentials measured in the hundreds of basis points. It’s the Fed that really matters for USD/JPY right now!

Crude, risk appetite other factors for USD/JPY traders

Outside shorter-dated US rates, there’s been a decent relationship with crude oil prices over the past month, potentially reflecting Japan’s susceptibility to higher energy prices as a major importer. While not as strong as earlier this month, evidence suggests USD/JPY continues to keep an eye on the S&P 500.

Each of those markets has ripped higher recently.

US two-year yields are up more than 50 basis points from January’s lows. WTI crude has added $7 per barrel in just a couple of weeks while the S&P 500 has surged nearly 9% from its YTD low, setting multiple record highs in the process.

They’ve run hard and fast, creating near-term reversal risks. Meanwhile, USD/JPY has not looked convincing above 150, balking at the opportunity to retest the November highs below 152. Given the speed of market moves, the correlation with USD/JPY and suspect price action in the latter recently, downside risks look to be building.

A hot US PCE inflation reading is expected Thursday

Thursday markets will receive the latest core PCE inflation reading in the United States. As the Fed’s preferred measure of underlying inflation, it will naturally get a lot of eyeballs. With the Cleveland Fed inflation nowcast model pointing to an increase in January of 0.32%, it’s safe to say most traders expect a hot outcome. It’s how the market will react that will be interesting.

Will traders continue to pare rate cut bets or is such an outcome already in the price? If we get a figure roughly in line with expectations and yields can’t pop, it will remove a key source of fuel for USD/JPY upside. Any result that undershoots could be expected to deliver decent downside should the relationship between US yields and USD/JPY be maintained.

USD/JPY bulls vulnerable should US yields reverse

Right now, USD/JPY remains rangebound between 149.60 and 150.90. On the downside, 148.80, 147.62 and 146.25 are the levels to watch. Above, a break of 150.90 opens the door to a retest of the November high.

Nikkei 225 vulnerable to sustained JPY strength

Under a scenario of sustained USD/JPY downside, the Nikkei 225 is another market to watch given it has a very strong relationship with USD/JPY, running with a correlation of 0.89 over the past month. While there are lot of positives contributing to the Nikkei’s surge, a weaker yen is significant factor helping to boost exporter earnings. That means a stronger yen may lead to Nikkei underperformance.

Support is located at 38855 on Nikkei 225 futures traded in Osaka. Below, the uptrend located around 38000 with 37000 the next level after that. A break of the record high of 39620 may see a push towards 40000.

-- Written by David Scutt

Follow David on Twitter @scutty