By :David Scutt, Market Analyst
- US-Japan interest rate differentials remain highly influential on USD/JPY movements
- Markets price over 100bps of Fed rate cuts in 2024 and more than 200 over the next 12 months
- US inflation, Treasury auctions key events for traders to watch this week
- Fed blackout begins before September FOMC meeting, meaning no official Fedspeak until Wednesday week
- Break of 141.70 could spark fresh wave of selling in USD/JPY
Overview
Interest rate differentials between the United States and Japan continue to drive movements in USD/JPY, maintaining the vice-like grip that’s been in place for most of the past few years. Further correlation analysis suggests the reaction function is being influenced by the shifting US interest rate outlook, rather than Japan. With yield differentials between the two nations collapsing to multi-year lows, based purely on that metric, risks for USD/JPY appear skewed to the downside.
US-Japan rate differentials collapse
The left-hand side pane in the chart below looks at interest rate differentials between the US and Japan going back to the start of 2022. Two-year differentials are shown in blue with those for five and 10-year tenors presented in orange and aqua respectively.
Two and five year spreads have narrowed sharply over recent months, compressing to levels not seen since mid-2022. Spreads for benchmark 10-year yields are threatening to follow suit , holding only marginally above the levels seen during the US regional banking crisis in early 2023.
When you look across to the right-hand pane to look at the USD/JPY daily chart, what is obvious that in mid-2022 and early 2023, the cross was trading at considerably lower levels, implying that purely from a rate differential perspective, USD/JPY comes across as elevated event after recent declines.
And that’s what driving USD/JPY moves
It’s obvious from correlation analysis that interest rate differentials remain an important driver of USD/JPY movements, be it over shorter or longer timeframes.
This next chart looks at rolling correlations USD/JPY has had with a variety of different spreads and individual US and Japanese yields. The pane on the left is the rolling 20-day correlation with the right pane the 60-day correlation, designed loosely to look at the relationship over the past month and quarter.
Whether you’re talking spreads over two, five or ten years, or movements in two-year US Treasury yields, the relationship has been incredibly strong over the past month and quarter.
Focus on Japan’s rate outlook unhelpful
I’ve also added correlation analysis with Japanese two-year yield spreads which reveals there’s been no strong relationship over either timeframe, reinforcing that despite the attention it receives, speculation over what the Bank of Japan (BOJ) will do with interest rates is not a major factor influencing USD/JPY movements.
As outlined previously, talk of the BOJ lifting interest rates again is nothing new. Markets have around 20 basis points of hikes priced in over the next 12 months, so hawkish talk from Governor Ueda and other officials needs to be treated as confirming market pricing, not pushing back against it.
Click the website link below to get our exclusive Guide to USD/JPY trading in H2 2024.
https://www.cityindex.com/en-au/market-outlooks-2024/h2-usd-jpy-outlook/
Fed blackout begins as rate cut bets swell
With the Fed blackout period before the September FOMC in force, it will be left up to economic data, known Fed mouthpieces in the media, and potentially the performance of risker asset classes to determine how the US interest rate outlook may evolve over the next week.
The next chart shows a lot of easing has already been priced in by markets.
35 basis points of cuts remains priced for the September meeting, implying a smaller 25 basis point move is marginally favored. Looking over longer timeframes, 118 basis points of cuts are priced over the remaining three FOMC meetings in 2024, suggesting at least one super-sized 50 is on the way with increased risk of a second. In the eight meetings over the next 12 months, 225 basis points of cuts are priced.
It’s aggressive and risks being unwound somewhat if the data suggests the US economy is on track for soft landing with no major deterioration in labour market conditions. However, there’s not much on the calendar this week that could bolster than view with only consumer price inflation, producer price inflation, jobless claims and three, 10 and 30-year bond auctions for markets to navigate.
Managing event risk
Even though the Fed has shifted to prioritising its full employment mandate over price stability, the CPI and PPI reports on Wednesday and Thursday respectively could generate a big unwind in rate cut pricing should they come in hot. That’s always a risk, but given the prevailing trend we’ve seen recently, it comes across as unlikely.
Realistically, given the influence yield spreads have on USD/JPY, the US three, 10 and 30-year bond auctions on Tuesday, Wednesday and Thursday respectively may be the biggest risk event for USD/JPY traders to navigate this week. Yields have fallen a long, long way, testing buyer demand.
I suspect Tuesday’s US Presidential debate will create plenty of headlines but no lasting market volatility unless there’s a clear and obvious winner through the lens of an impartial judge.
141.70 looks key for USD/JPY
USD/JPY looks heavy on the daily chart, dragged lower by narrowing yield spreads. Having failed to reclaim the former uptrend in August, the pair remains very much a sell-on-rallies play. RSI (14) has rolled over while MACD looks like it may soon crossover from above, confirming the bearish signal on momentum. We’ve even seen a death cross take place with the 50-day moving average crossing over the 200-day from above, although its recent track record is not convincing when it comes to directional risks.
On the downside, 141.70 looms as important, bottoming there during the early August rout and then holding above it on Friday despite the continued decline in US yields. But if it were to give way, it could spark a fresh wave of bearish bets, increasing the risk we may see a probe towards 140.273 or 138.00, the latter an important level the price did plenty of work either side over the past two years. On the topside, 143.63 and 147.06 are levels to watch this week.
– Written by David Scutt
Follow David on Twitter @scutty
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