USD/JPY: Waning inflationary pressures, steady BOJ bond buying points to upside risks

• Business activity in Japan is expanding at the fastest pace this year, but inflationary pressures are moderating
• BOJ keeps bond buying steady, tempering rate hike expectations
• USD/JPY hits highest level since suspected BOJ intervention episode

Business activity in Japan is expanding at the fastest pace in almost a year, signalling economic growth may rebound in the June quarter after a shock decline in the first three months of the year. However, inflationary pressures continue to moderate, creating doubt over the ability for the Bank of Japan to increase rates further without spiraling the economy back into deflation.

For the moment, USD/JPY continues to drift higher, underpinned by improved risk appetite and gaping yield differentials between the United States and Japan.

Japan’s economy showing improvement, but inflation is softening

The “flash” au Jibun Bank Flash Japan Composite PMI from S&P Global rose to 52.4 in May, making the fastest expansion in activity since August 2023.

PMIs measure changes in activity from one month to the next, looking at different components such as sales, new orders, order backlogs, employment, output, along with input and output prices. A reading of 50 indicates activity was unchanged from a month earlier. The further above 50 the figure is, the greater the magnitude of improvement.

Source: S&P Global 

The 52.4 reading marked the third consecutive month of improvement, driven by continued growth from services firms and a welcome stabilisation in Japan’s manufacturing sector.

“This indicated that growth momentum continued to improve midway into the second quarter of 2024 and hints at a better Q2 GDP reading, after the disappointing first quarter print,” S&P Global said.

The services PMI eased from 54.3 to 53.6 while the manufacturing reading lifted from 47.8 to 49.8, indicating a far slower pace of contraction.

However, the news was not fantastic on the inflation front with input costs and output price growth easing over the month, something S&P Global said may prelude “softer inflationary pressures across official gauges.”

BOJ moves to temper rate hike hopes

An hour after the report was released, the Bank of Japan announced purchases of Japanese government bonds will remain unchanged in upcoming operations, refraining from making a further reduction which sparked speculation over further rate hikes from the BOJ earlier this month.

USD/JPY continues to grind higher

With Nvidia’s first quarter earnings report helping to boost investor sentiment and interest rate differentials between the US and Japan remaining at historically elevated levels thanks to continued delays to rate cuts from the Fed, USD/JPY continues to drift higher for the moment.

Looking at the four-hourly chart, USD/JPY is testing the high of 156.85 set on May 14, seeing it hit levels not seen since the suspected BOJ intervention episode in late April.

With momentum to the topside, traders may want to consider buying the break of 156.85 should it occur, targeting a move back to 158 where the pair topped out at the start of the month. A tight stop below would offer protection against reversal.

As for the threat of potential for further BOJ intervention, Japan’s Ministry of Finance has been noticeably quiet of late. That’s important as it instructs the BOJ on what to do. On the US side of the ledger, there is no major economic data out until next Friday with the release of the PCE inflation report, likely ensuring Fed members will continue to preach patience on the prospect of rate cuts this year.

-- Written by David Scutt

Follow David on Twitter @scutty