USD/JPY unwind risks grow as yield spreads compress to cyclical lows

Yield spreads between US and Japanese 2, 5 and 10-year debt fall to fresh cyclical lows
Based purely on yield differentials, USD/JPY looks expensive
Markets price in nine Fed rate cuts over the next year, returning to levels the Fed believe are neutral for unemployment and inflation
If the need to stimulate the economy grows, the Fed may cut even more aggressively
USD/JPY eyeing 2021 uptrend test

Overview

With yield differentials between the United States and Japan compressing to multi-year lows across multiple tenors, you have to wonder whether it may spark a fresh round of forced carry trade unwinds in USD/JPY as seen in early August?

Because unless we see a significant hawkish shift in the US interest rate outlook akin to that witnessed earlier this year, or an unlikely surge in asset values from already historically elevated levels, it suggests directional risks for USD/JPY remain skewed to the downside.

USD/JPY looks elevated relative to yield spreads

From a purely interest rate differential perspective, USD/JPY looks overvalued at current levels even with the recent unwind from above 160.

The left-hand pane on the chart above shows the spread between US and Japanese 2 (blue), 5 (red) and benchmark 10-year (black) bond yields, revealing that after a further decline on Tuesday, each sits at lows not seen since around August 2022. The bottom pane is the rolling 20-day correlation USD/JPY has had with two-year yield spreads, underlining the strong relationship the two have right now.

To the right, it’s simply the USD/JPY daily chart marked with where the pair was trading around when spreads were last at these levels. Clearly, around 142, the pair remains well above the levels seen back then.

While yield differentials are not the only factor to consider, with trade flows along with asset valuations important, you can’t ignore that the lure of higher interest rates in the United States for those borrowing in yen is starting to wane. That contributed to the large decline in USD/JPY in early August and it could easily do so again as spreads have compressed even further.

Fed pricing aggressive for a reason

Looking quickly at the US interest rate outlook, 33 basis points of cuts are priced into the Fed funds futures curve for September, implying around a one in three chance of a 50 being delivered. Over the remaining three FOMC meetings of 2024, 116.5 basis points are priced. Over the next year which captures eight Fed meetings, 231.5 basis points are expected.

It’s an aggressive profile, no doubt, but even with the amount of rate cuts priced over the next year, it would only get the funds rate back to around the levels where the Fed believes will keep inflation and unemployment steady. While a theoretical level, the read-through is that if the Fed believes the economy needs outright stimulation, it could cut even harder than markets imply.

The Fed is highly unlikely to signal that in its updated dot plot at the September FOMC meeting because it would only act to stoke recession fears, but it will likely signal more rate cuts than the median projection of five out to the end of 2025 provided three months ago. That may help to keep downward pressure on spreads as markets have tended to overstate Fed projections in anticipation of this easing cycle.

USD/JPY breaking bullish uptrend

USD/JPY on the weekly chart looks increasingly shaky for long-term bulls, breaking uptrend after uptrend in recent months, leaving only the January 2021 trendline to go. In between, 141.70 is the first downside level of note, marking the low struck in early August. If it were to go, 140.25, the January 2021 uptrend and 137.70 are the next levels of note. The key reversal candle last week warns of growing downside risks.

If we were to see a bounce, 143.80 may encounter resistance. Last week’s high around 147.20 is another, although it would need a major turnaround in market pricing for the Fed.

-- Written by David Scutt

Follow David on Twitter @scutty

StoneX Europe Ltd makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied. You should always seek independent advice as to your suitability to speculate in any related markets and your ability to assume the associated risks, if you are at all unsure. We are not under any obligation to update any such material. Any opinion made may be personal to the author and may not reflect the opinion of StoneX Europe Ltd.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Please ensure you fully understand the risks involved by reading our full risk warning.

FOREX.com is a trading name of StoneX Europe Limited, and FOREX.com/ie is a domain operated by StoneX Europe Ltd, a member of StoneX Group Inc. StoneX Europe Ltd, is a Cyprus Investment Firm (CIF) company registered to the Department of Registrar of Companies and Official Receiver with a Registration Number HE409708, and authorized and regulated by the Cyprus Securities & Exchange Commission (CySEC) under license number 400/21. StoneX Europe is a Member of the Investor Compensation Fund (ICF) and has its registered address at Nikokreontos 2, 5th Floor, 1066 Nicosia, Cyprus.

StoneX Europe Limited is registered with the German Federal Financial Supervisory Authority (BaFin). BaFin registration ID: 10160255

FOREX.com is a trademark of StoneX Europe Ltd, a member of StoneX Group Inc.

The statistical data and the awards received refer to the Global FOREX.com brand.

This website uses cookies to provide you with the very best experience and to know you better. By visiting our website with your browser set to allow cookies, you consent to our use of cookies as described in our Privacy Policy.

Through passporting, StoneX Europe is allowed to provide its services and products on a cross-border basis to the following European Economic Area ("EEA") states: Austria, Bulgaria, Croatia, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden.

Additionally, StoneX Europe Ltd is allowed to provide Investment and Ancillary Services to the following non-EU jurisdiction: Switzerland.

StoneX Europe Ltd products, services and information are not intended for residents other than the ones stated above.

Tied Agent Information: KQ Markets Europe Ltd with Company No. HE427857.
Address: Athalassas 62, Mezzanine, Strovolos, Nicosia Cyprus.
Services Provided: Reception and Transmission of Orders.
Commencement Date: 06/12/2022
Website: KQ Markets - CFD Trading | KQ Markets

We may pay inducements, such as commissions or fees, to affiliates or third-party introducers for referring clients to us. This is in line with regulatory guidelines and fully disclosed where applicable.

StoneX Europe Ltd may make third party material available on this website which may contain information included but not limited to the conditions of financial markets. The material is for information purposes only and does not contain, and should not be construed as containing, investment advice and/or investment recommendation and/or an investment research and/or an offer of or solicitation for any transactions in financial instruments; any decision to enter into a specific transaction shall be made by the client following an assessment by him/her of their situation. StoneX Europe Ltd makes no representation or warranty and assumes no liability as to the accuracy or completeness of the information provided, nor any loss arising from any investment based on a recommendation, forecast or other information supplied. You should always seek independent advice as to your suitability to speculate in any related markets and your ability to assume the associated risks, if you are at all unsure. We are not under any obligation to update any such material. Any opinion made may be personal to the author and may not reflect the opinion of StoneX Europe Ltd.