USD/JPY forecast: What a hawkish Fed giveth, a dovish Fed can taketh away

• USD/JPY pulls back from multi-decade highs
• US dollar softens as Fed rate cut bets swell
• Jerome Powell speech, US inflation report headline event risk this week
• Topping pattern on the weekly, price looks heavy on the daily
• For the first time in a while, directional risks may be shifting to downside.

After a rare reversal in USD/JPY to start July, traders should be on the lookout for any follow through selling as expectations for Fed rate cuts this year swell. Considering higher US yields helped to propel the dollar higher, if you take that away, can the prevailing trend realty be maintained?

This report looks at what’s been influencing USD/JPY, market pricing for the Fed and BOJ interest rate outlook, key event risk this week, and a technical assessment on a daily and weekly timeframe.

USD/JPY key influences

To get a sense you should be watching aside from the evolving price action, I like to look at a rolling daily correlation between USD/JPY with various market variables over the past month, screening them for relevance to reduce the risk of false signals. Correlation does not mean causation.

With a score of 0.91, USD/JPY and WTI crude futures have been strongly correlated. LNG futures have also been loosely correlated over the same period with a score of 0.56. Combined, it suggests firmer prices and Japan’s standing as a major energy importer may be contributing to yen weakness through the current account channel. Watch energy markets!

Elsewhere, the correlation with S&P 500 e-mini futures sits at 0.68, hinting risk appetite and carry trade flows continue to create headwinds for the low-yielding yen.

The relationship between expectations for Fed rate cuts over the next year, and yield spreads between the US and Japan across a variety of different tenors, has been negligible to non-existent. Unusual but not unheard of over short timeframes.

It may also pay to keep a close eye on the USD/CNH which has often acted as a lead indicator for USD/JPY recently. And its correlation with USD/JPY has been 0.95 over the past month. Near-lockstep territory. 

Fed rate cut bets swell, yield differentials compress

Given they’ve been influential on USD/JPY in the past, spreads between US and Japanese government bond yields for two, five and ten-year tenors are show below. While not a straight line, they continue to compress relative to levels seen over the past year. Should they reassert themselves again, that hints at downside directional risks for USD/JPY.

The Fed funds futures curve – shown in the bottom pane – has 108 basis point of easing priced between June 2024 and June 2025, equating to just over four 25-point rate cuts during that period. That’s more than double the level seen in early May.

For the BOJ rate outlook, one-year overnight index swaps sit at 0.2425%. That equates to an expectation its benchmark overnight rate will sit at 45 basis points in one year’s time, up from 0-0.1% currently.

Powell, US inflation report key risk events

Following the soft US nonfarm payrolls report on Friday, it’s likely Jerome Powell will continue to provide dovish signals to Senate lawmakers when he appears before them on Tuesday. Markets are priced for two rate cuts this year, with a 75% probability of the first move coming in September. It’s doubtful Powell will push back on those expectations. Job market conditions and inflationary pressures are softening and the Fed thinks policy settings are very restrictive, so the justification for remaining hawkish is diminishing.

Thursday’s US consumer price inflation report is the main threat to the dovish outlook, especially given upside surprises in other developed nations recently. However, such an outcome would be at odds with deteriorating activity and limited by persistent US dollar strength, diminishing the threat posed by tradable inflation.

Other notable market events

Outside of Powell and the inflation report, other events to keep note include the New York Fed’s consumer inflation survey on Monday, Japanese producer price inflation on Tuesday, Thursday’s US jobless claims figures, along with producer price inflation and Uni of Michigan consumer sentiment numbers on Friday.

While rates are not particularly influential on USD/JPY right now, given its long history of being driven by them for extended periods, auctions of three and ten-year Treasury notes on Tuesday and Wednesday respectively, and a 30-year bond auction Thursday, have the potential to move US yields and dollar-yen. Given the dovish move in rates markets last week, demand is expected to be firm. 

Events listed are US EDT.

USD/JPY long-term technical picture

Weekly charts are great for turning down the noise to get a better signal on prevailing trends. Looking at USD/JPY, it remains in a strong uptrend with indicators such as RSI and MACD signalling momentum remains to the upside. Until the uptrend is broken, meaningful pullbacks are still likely to be bought.

However, last week’s tombstone doji is a candle often seen around market tops. And while RSI remains in an uptrend, it has diverged from price in recent months, printing lower highs as the price surged to multi-decade peaks. That’s a warning of waning bullish momentum. If USD/JPY were to decline further this week, it will strengthen the bearish signal.

Zooming in

When you zoom in to a daily timeframe, the picture is one of a market that looks toppy. While dips off the lows were bought on Thursday and Friday, that was on wafer-thin volumes. RSI has also broken its uptrend, hinting at shifting momentum risks. MACD is also threatening to crossover from above, generating another potential bearish signal. USD/JPY looks heavy.

160.23 is an important downside level to watch, marking the point where the BOJ was instructed to intervene to counteract yen weakness in late April. Should that give way, uptrends that began earlier this year and the important 50-day moving average will be on the radar for bears.

One trade idea would be to initiate shorts on a break and close below 160.23, allowing for a stop to be placed above the level for protection. Other than the downtrends and 50-day moving average, 159.92, 159.20 and 158.25 are other levels that could be used as targets.

Despite the heavy picture, should USD/JPY be unable to break and close below 160.23, consider buying the dip with a stop below the level for protection. 161.70 and 161.95 are potential targets.

-- Written by David Scutt

Follow David on Twitter @scutty