USD/JPY and Nikkei 225 vulnerable should yield differentials continue to compress

• USD/JPY often has a strong relationship with US bond yields. And the Nikkei 225 is often influenced by USD/JPY
• US-Japan yield spreads have compressed to levels not seen in months. USD/JPY is well above where it was trading when they were this low.
• The relationship between USD/JPY and yields can weaken on occasion but rarely lasts for long.
• A stronger yen may act as an earnings headwind for Japan’s exporters.

It’s no secret yield differentials can be a key driver of USD/JPY movements on occasion, rising and falling as spreads with other currencies expand and contract, shifting the relative appeal of the yen. It’s also obvious that for Japan’s massive export sector, a weaker yen can provide tailwinds for corporate earnings, making Japanese goods and services more competitive relative to competitors abroad.

Put simply, bond yields, especially in the United States given the US dollar’s role as the global reserve currency, are perhaps more important to Japan than many other parts of the world.

USD/JPY isn’t moving in lockstep with yields… for now

However, the relationship between USD/JPY and yields has weakened somewhat over the past month, with the yen far weaker now that where it began the year despite a noticeable decline in yields across much of the US bond curve. While not unusual, during a time when there’s so much focus on what the Federal Reserve and Bank of Japan may do with rates over the coming months, the sudden disinterest comes across as a little unusual.

US-Japan yield spreads compress to multi-month lows

Looking at the chart below from Refinitiv, the yield spread between US and Japanese benchmark 10-year debt has compressed to the lowest level seen this year, threatening to push back to lows not seen since May 2023. Shorter duration debt, such as two and five-year tenors, have already surpassed the lows hit in December with market were pricing in as many as seven rate cuts from the Fed in 2024.

Source: Refinitiv 

USD/JPY six big figures above where it began 2024

Whereas yields have fallen, USD/JPY has not. It’s trading around six big figures higher than where it was yield spreads were last around these levels. While still positive at 0.65, the correlation between USD/JPY and movements in US 10-year yields over the past month has fallen from above 0.9, easing to levels last seen in November when the Fed pivot party was in full swing. Looking at other inputs such as the USD index, there’s been no noticeable change in relationship with USD/JPY over the same period.

Perhaps the turn of the calendar year and subsequent influence on capital flows, or even risk aversion from geopolitical tensions in the Middle East helping to boost the energy rich greenback, may explain the weakening in the correlation.

While the relationship can and has been weaker than now over the past year, even turning negative on occasion, one thing that stands out is that the relationship rarely remains weak for long. With yields sitting around these levels, if a similar scenario plays out, it points to downside risks for USD/JPY.

USD/JPY downside momentum is building

As mentioned earlier, USD/JPY is trading well above the 140.80 level it bounced off when US-Japan benchmark yield spreads were last this skinny. It’s currently sitting in a narrow range between 148.40 and 146.50, with the 50 and 200-day moving averages not far below the latter. Perhaps that explains the reticence of traders to seek out downside from these levels, with the price respecting both these levels on occasion over recent years. But not every time.

Looking at the risk-reward for initiating a short position, a stop above 148.40 targeting a return to the December lows around 140.80 appears reasonable, especially with momentum indicators such as MACD and RSI pointing to building downside momentum.

While there are risk events on the horizon, including US non-farm payrolls, it would likely require an unexpected and unlikely strengthening in lagging labour market conditions to deliver a meaningful recovery in US yields. Renewed concerns about US regional banks is another consideration, although its too early to speculate that it’s endemic of broader systemic problems.

A stronger yen may hit the Nikkei 225

For those who think yen strength may be on the cards, another trade opportunity comes from shorting the Nikkei 225. Looking at the index and USD/JPY over the past month, the correlation remains strong and relatively stable at 0.79. Unsurprisingly given the relationship between the two, the momentum indicators on Nikkei 225 futures are not dissimilar to USD/JPY. RSI has also converged, setting lower highs as the price rocketed to record highs. While sentiment remains near-euphoric after the Nikkei’s break to fresh multi-year highs, that can also make it vulnerable to reversal given how hard its run.

Those contemplating a short could place a stop above the current record high around 37000 targeting a move back to the top of the range futures were capped below for much of last year at 33750. Between entry and target, only minor horizontal support around 35280 is event on the charts.

-- Written by David Scutt

Follow David on Twitter @scutty