USD/JPY, Nikkei 225: Watching yield spreads for clues on when the rout may reverse

• Nikkei 225 futures are being influenced by USD/JPY movements
• USD/JPY is being influenced by interest rate markets
• Relative yield differentials may provide clues when USD/JPY, Nikkei may bottom
• US non-manufacturing PMI has potential to intensify rout or spark major reversal

Rates markets the area to watch

If the Nikkei 225 outlook is a function of moves in the Japanese yen due to the impact on exporter earnings, what should traders monitor to gauge when USD/JPY may bottom? Because right now, the risk-off tone in FX is flowing through to equities, feeding upon one other to create an ugly snowball effect in Japanese markets.

As this note explains, interest rate markets, especially the front-end of curves and relative spreads, may provide clues as to when USD/JPY, and eventually Nikkei 225, may find a floor.

USD/JPY heavily influenced by relative rate differentials

To begin, the chart below looks at the rolling 20-day correlation between USD/JPY and other indicators to get a sense as to what’s been influencing dollar-yen over the past month.

From top to bottom, the variables are one-year ahead expectations for the Fed funds rate, proxied by the shape of the futures curve between June this year and next, two-year, five-year and 10-year year yield spreads between the United States and Japan, and finally Nasdaq 100 futures.

USD/JPY has been strongly correlated with each  over the past month, demonstrating that interest rate markets and risk appetite have been influential on USD/JPY movements. But rather than weakness in riskier assets preceding moves in USD/JPY, the strong correlation comes across as a function of carry trade unwinds being driven by narrowing interest rate differentials between the US and Japan.

Rate differentials had been warning of this for a while

As seen in this next chart, well before riskier asset classes and USD/JPY started rolling over, it was spreads that were forewarning about a potential shift in market direction. Two-year yield spreads between the US and Japan – which have had the strongest correlation with USD/JPY over the past month – have been compressing since May, a move at odds with USD/JPY which continued to grind higher.

So, if the relationship sticks, relative rate differentials between the US and Japan may provide clues as to when USD/JPY and Nikkei 225 may bottom. As yet, there’s no sign of relative spreads starting to widen again, pointing to the potential for more downside ahead for Japanese stocks and a stronger Japanese yen.

US non-manufacturing PMI key release

As I explained in a separate post looking at the EUR/USD outlook this week, in the near-term, Monday’s US non-manufacturing PMI report for July is likely to be highly influential on sentiment as to whether the US economy is heading for recession.

If it confirms the recessionary signals from other recent data releases, it may lead to markets piling on even greater Fed rate cut bets, potentially compressing rate differentials further. But, if it doesn’t, we could see a savage reversal take place.

USD/JPY slicing through major supports

Looking at the technical picture for USD/JPY, I prefer the weekly timeframe as it provides a far stronger message on the levels that matter in this time of market turbulence. Extending the move seen on Friday, the pair has now taken out the January 2023 uptrend and horizontal support at 148.50 established in March this year.

On the downside, the next major levels include 140.25 before we get to the intersection of the 2021 uptrend and major horizontal support located from 137.70. If they were to give way, it would imply another major increase in Fed rate cut bets driven by hard landing fears. Above, 146.50, the Jan 2023 uptrend, 150.90 and 151.95 are the levels of note.

Nikkei 225 melting down after melt-up

Turning to Nikkei 225 futures, the next major downside level is found around 33700, a resistance level that capped gains throughout much of 2023 before the bullish breakout earlier this year. Below, 30,000 would be the next port of call. On the topside, there is little major resistance of note until 36985.

-- Written by David Scutt

Follow David on Twitter @scutty