Early on Thursday, USD/JPY reversed course after advancing on Wednesday. What weighs down on the US dollar, and can the pair continue its rally?
Hawkish support for USD
On Wednesday, the US dollar continued to climb against the Japanese yen after surging upwards earlier. Tuesday's US inflation data, which was hotter than anticipated, sent the pair to a 6-week high at 133.3.
Traders discovered that consumer price inflation in the US remains steady despite the Fed's aggressive policies. As a result, markets have become more confident that the US central bank will have to put more effort in bringing inflation down to its target level of 2%.
Yesterday's macroeconomic data further convinced investors of this and only fuelled the US dollar rally. USD/JPY jumped by more than 100 pips in the middle of the week and surpassed the key psychological level of 134.00.
This move was triggered by optimistic US retail sales data, which surpassed expectations.
According to the US Commerce Department, retail sales in the US increased by 3.0% in January year-over-year, greatly surpassing the forecasted 1.8% increase.
"The US economy continues to operate well. There's very strong labor market data coming through, and the consumers are well supported. We do think the Fed's got a little bit more work to do," Jarrod Kerr, chief economist at Kiwibank, said.
Given the latest macroeconomic data, most market players now expect the Federal Reserve to maintain its hawkish monetary policy and raise the interest rates by 5.2% in July. Earlier forecasts suggested the interest rates would peak at 5%.
"It's not just that we have renewed expectations for now 25 basis points in March and then 25 as expected in May, but also the possibility that rates have to stay higher for longer. So, where is the plateau? Every day that goes by, the 2% inflation target for the Fed seems a bit far into the distance," Ivan Asensio, head of FX at Silicon Valley Bank in San Francisco commented.
The fact that the US will now stick to a dovish course drives the US dollar higher, particularly against the Japanese yen, which is affected by the Bank of Japan's dovish policy.
USD/JPY averaged at around 132.08 in January 2023, which was 15% higher than a month prior. However, many analysts believe that the US dollar's dominance over the yen could soon come to an end. What is the main risk for USD?
Kazuo Ueda looms over USD/JPY
At the beginning of this week, confirmation hearings for the next BOJ governor took place in the Japanese parliament. The government of Japan has chosen the 71-year old academician Kazuo Ueda to replace Haruhiko Kuroda as the chief of the Japanese central bank. Kuroda will step down on April 8.
Kazuo Ueda is perceived as a moderate policymaker who favors neither dovish nor hawkish policies.
Last week, before his nomination as the next governor of the Bank of Japan, Ueda told journalists that he considered the ongoing BOJ monetary policy to be appropriate and that he would continue it if he became governor.
Nevertheless, many analysts expect Ueda to take the first hawkish steps after taking office in April. Given the crisis in the local bond market, experts believe that the new BOJ governor will decide to tweak the yield curve control mechanism or abandon it altogether.
The YCC was introduced 10 years ago when Haruhiko Kuroda became governor of the Bank of Japan. To support Abenomics, an aggressive attempt by then-Prime Minister Shinzo Abe to revive the ailing economy, the Japanese regulator significantly increased purchases of government bonds and eventually moved to limit yield growth.
In 2022, as interest rates rose globally, Japanese bond yields began to come under increased pressure from bond sellers. In order to prevent yields from rising and to keep the rate below the set limit, the Bank of Japan conducted unlimited purchases of bonds on the market.
When the problem finally got out of control, the regulator expanded the target range for government bond yields twofold in December 2022. However, this measure later proved to be insufficient.
As speculations about a possible U-turn by the Bank of Japan intensified, bond bears became even more active in the market, which provoked another jump in government bond yields.
This forced the BOJ to make increasingly larger purchases. In January alone, the regulator spent a record 23 trillion yen to keep the yield below the established ceiling.
Experts predict that the change in BOJ leadership will not only lead to a setback, but also further aggravate the situation in the Japanese bond market.
Under these circumstances, Ueda may realize that he has no choice but to push the red button as soon as he takes office in April.
"A dramatic shift in policy would be unwise. Abrupt tightening of fiscal and monetary policy could bring on a recession that the central bank no longer has the tools to reverse. But cautious steps to normalize monetary policy are necessary. These should include either a modest increase in the rate ceiling imposed by yield curve control or - better - a switch from a cap on yields to a more orthodox schedule of gradually diminishing asset purchases," analysts at Bloomberg stated.
According to experts, if Ueda decides to roll back the YCC, it will result in the yen rising strongly against the US dollar.
Economists at Westpac see USD/JPY come under pressure from rising speculation about the possible abandonment of the yield curve control policy in the foreseeable future.
The longer-term outlook for USD is now also negative. Westpac estimates that by the end of the year the pair will trade at 129 and fall to 124 a year later.
Lower US interest rates and reduced monetary policy divergence between the Fed and BOJ will be the headwinds for the dollar-yen pair.
