USD/JPY upside getting difficult as US economic data rolls over

• Evidence is accumulating to suggest US economic growth is rolling over
• USD/JPY has been highly influenced by Fed rates expectations recently
• Wednesday’s ISM services report has taken on added significance for markets

USD/JPY is on the backfoot at the start of June, hit by narrowing yield differentials and a whiff of concern about the trajectory for the US economy. Data releases in the coming days may provide clarity on the answer, providing ample two-way price risk given elevated levels of uncertainty.

Asymmetric risks for US rates on display

Risks for US rates were always asymmetric around these levels, with upside far harder won than downside given the higher rates go the more likely it will spark a hard economic landing. We saw that playout on Monday with the ISM non-manufacturing PMI sparking a massive rally across the US Treasury curve, led by the short end which is heavily influenced by Fed rate expectations.

Two-year yields slumped 8 basis points, taking them to within touching distance of a level I’ve described as something of a dividing line for the higher for longer narrative. Markets now favour two rate cuts from the Fed in 2024 rather than one. 

So why the big reaction in the bond market? While the detail was undeniably weak with activity contracting at a faster pace in May while lead indicators such as new orders tanked, the substantial bid in bonds was arguably just as much driven by where yields were sitting up until just a few days ago.

Up until last week two-year yields were flirting with 5%, a level they’ve struggled to push beyond throughout this Fed tightening cycle. But with the Fed’s preferred inflation measure, the core PCE deflator, revealing the gradual disinflation trend has resumed after a hot start to the year, focus has now shifted to how activity indicators are holding up.

Abrupt US slowdown already here?

Even before the weak manufacturing PMI came across the screens, evidence was quickly accumulating to suggest growth is rolling over. Citi’s US economic surprise index turned sharply negative, indicating more data than not was surprising to the downside relative to consensus economist forecast. Soft surveys such as the Chicago PMI were outright recessionary.

Personal consumption is also faltering, declining in April once adjusted for inflation, extending the slowdown seen in the first three months of the year. It’s little wonder the Atlanta Fed GDPNow forecast model now has the economy expanding at an annual pace of 1.8% in the June quarter, down nearly two full percentage points on the level indicated two weeks ago.

Source: Atlanta Fed

Just as economic activity has started to splutter, yields were flirting with 2024 highs, likely explaining why the Treasury market reacted so aggressively to one single data point. But now focus is acutely on activity data, any reports that can confirm or question the growth slowdown narrative will be influential not only on bonds but also USD/JPY given its sensitivity to yield differentials.

ISM services takes on added significance

While most pundits are looking to Friday’s nonfarm payrolls report for clarity, Wednesday’s ISM services PMI has now arguably taken on more significance for markets. Unlike lagging payrolls which reflects where the economy is coming from, the services PMI print provides a near real-time measure of activity across the most important part of the US economy. If it confirms the signal in the manufacturing PMI, the reaction could be huge given we're talking about a far more important part of the economy. 

For anyone trading USD/JPY or other rate sensitive asset class, this is the report to watch, especially the prices paid, employment and new orders sub-indices. If they weaken noticeably, the likely compression in yield differentials could hammer USD/JPY lower. But if it contradicts the slowdown narrative, as the separate S&P Global US Services PMI report did a fortnight ago, there’s every chance US bond yields and USD/JPY may squeeze higher.

Tuesday’s calendar devoid of major risk events

While it is another busy US calendar on Tuesday, nothing looms as being particularly market moving for USD/JPY unless horribly weak. On that front, the  volatile JOLTS survey could dish up anything given you can drive a Mack truck through its margin of error. If you are looking for some form of signal, you’d be better off looking at the quits rate rather than headline figure. People don’t tend to quit unless they’re confident they’ll have a job to go to, right?!

USD/JPY short-term technical outlook

Like the impact on US bond yields, the ISM manufacturing report left its mark on USD/JPY, delivering a fat inverse hammer candle, taking out support at 156.57 and minor uptrend dating back to the start of May. With RSI breaking its uptrend simultaneously, bears have the ascendency near-term.

Should the ISM services report confirm the weakening growth signal in other surveys, minor support at 155.55 may break like a twig in a hurricane, putting USD/JPY on track for a potential test of the 50-day moving average at 154.74.

But if the figure wrongfoots the market and points to economic resilience, USD/JPY may squeeze back above 157 unless it signals sharp softening in services inflation.

-- Written by David Scutt

Follow David on Twitter @scutty