USD/JPY forecast: Mind the (yield) gap as Fed, BOJ interest rate decisions collide

• USD/JPY continues to be driven by the US interest rate outlook
• Traders are split on whether the Fed will cut rates by 25 or 50 basis points in September
• USD/JPY likely to be influenced by longer-term Fed interest rate signaling
• BOJ set to keep rates steady, watch for volatility around Ueda’s press conference
• USD/JPY bias remains lower but watch for bear market rallies

US interest rate outlook remains key

US interest rates remain the driving force behind USD/JPY movements with increasing Fed rate cut bets narrowing yield differentials with Japan, resulting in repatriation of capital back into Japanese yen and discouraging new carry trades from being entered.

This chart shows that as yield spreads between the US and Japan compressed to levels not seen since 2022, it's coincided with a large decline in USD/JPY from above 160 to the low 140s. However, as this research note released last week explains, relative to where spreads currently reside, USD/JPY appears elevated even after recent falls.

Japan’s rates outlook only a secondary consideration

Providing further context about the important role US rate fluctuations are playing, the next chart below looks at the rolling 20-day correlation between USD/JPY with year ahead Fed rate cut pricing in red, US-Japan two, five and 10-year yield spreads in blue, green and black, along with US and Japanese two-year yields in purple and yellow respectively.

All variables except Japanese two-year yields sit with scores of 0.88 or higher, indicating that where they move, USD/JPY typically follows. The -0.64 score for Japanese yields demonstrate that it’s the US rate outlook that’s driving USD/JPY, not Japan’s. That means the key event this week is the Fed monetary policy decision on Wednesday. Everything else, including the BOJ rate decision on Friday, is secondary in importance. 

Fed: More about signaling than September

Rather than whether the Fed cuts rates by 25 or 50 in September, the far more important piece of information for USD/JPY traders will be the amount of rate cuts it signals in the future. To assess what it may do, you need to look at how unemployment and core inflation is faring relative to forecasts it issued three months ago. 

Back in June, it saw unemployment and core PCE inflation sitting at 4% and 2.8% respectively by the end of the year. However, unemployment has risen to 4.2% and is trending higher. At the same time, underlying inflation is softening, growing at 2.6% in the year to July. When you look at the six-month annualised pace, it's even weaker at 2.0%. 

So, unemployment is rising faster-than-expected while disinflationary pressures continue, all why the funds rate remains at 5.25-5.5%, around 260 basis points above the level the Fed believes will keep inflation and unemployment stable. One way or another, to limit the risk of the economy being tipped into recession, it needs to get cracking.

Source: Federal Reserve 

Given the softening in the labour market and inflationary pressures, there’s likely to be a meaningful adjustment to the amount of cuts signaled in the FOMC’s dot plot which takes the median member forecast for where the funds rate will sit at the end of each calendar year.

In June, it had one 25 basis point cut in 2024 and four in 2025. I expect it will signal three cuts in 2024 on this occasion and four in 2025, with risks in the latter tilted to more being added. While less than the 4.5 cuts traders have price for 2024 and nine over the next 12 months, this may not generate a material lift in US interest rates, nor help to boost USD/JPY sustainably, as markets have typically had a more dovish rates profile than Fed forecasts over the past year.

Jerome Powell’s press conference will also be important, especially as his messaging has been noticeably more dovish than other FOMC members recently. If he continues that pattern, it could create downside risks for US yields and dollar during and after his appearance.

BOJ done with surprises?

Unlike the Fed, the BOJ’s monetary policy meeting is expected to be a less exciting affair with none of the 52 economists polled by Reuters expecting overnight rates will change from around 0.25%. Nor will updated forecasts be released, lessening the risk of surprise.

In the absence of a shock move, that suggests that if there is to be any volatility, it will likely come from Governor Ueda’s press conference at 2.30pm JST. He’s likely to maintain the view that rates will increase further should their economic projections prove accurate and financial markets remain stable.

While three-month overnight index swaps (OIS) trade near the current overnight rate, one-year OIS trade at 0.3475%. As this measures the expected average overnight rate over the next year, it suggests around another 20 basis points of hikes are priced over this period.

Source: Refinitiv 

USD/JPY biased lower but beware bear market rallies

The key reversal on the weekly chart in early September warned of increasing downside risks, seeing USD/JPY take out the early August lows on Wednesday. Should we see a further compression in yield differentials or a risk-off environment that leads to weakness in riskier asset classes, downside pressure may intensify further.

On the downside, 140.23 is the first level of note, coinciding with the market bottom of late December 2023. The price bounced off this level on Friday, suggesting buyers are defending it for now. Below, the 2021 uptrend, 137.70 and even 133.60 should be on the radar if we see forced carry trade unwinds.

While the bias remains lower, you can't discount the threat of rapid short-covering rallies given how far USD/JPY has fallen recently. If the Fed delivers a 25 basis point cut and provides a message far less dovish than market pricing, USD/JPY could squeeze higher, bringing resistance at 141.70, 143.80 and above 147 into play.

The wide range of levels indicated is reflective of just how volatile the week could be. While momentum is with the bears, keep a watch on price signals on smaller timeframes for potential turning points. 

-- Written by David Scutt

Follow David on Twitter @scutty