USD/JPY Outlook: Bulls get a lifeline from the bond bloodbath

• US-Japan yield spreads widen at a historically rare pace
• USD/JPY falls despite a strongly supportive rates backdrop
• Record intervention and US support keep yen strength intact
• Bullish engulfing candle puts reversal risk firmly in play
• US CPI, energy prices loom as the key near-term catalysts

Bond bloodbath hands USD/JPY bulls a lifeline

The very thing so many markets are worrying about right now, rising bond yields, could prove to be something of a boon for USD/JPY bulls.

US Treasury yields have backed up sharply from their late-August lows, particularly at the front end of the curve, as higher energy prices, firmer inflation pressures and rising expectations for a Fed rate hike push borrowing costs higher.

Looking back over time, that’s exactly the kind of backdrop that would normally support gains for USD/JPY. Instead, the pair has fallen sharply over the past couple of weeks.

While the disconnect is unusual, there are obvious reasons behind it. The question now is which one wins out: the factors that led to the unwind in USD/JPY, or the historical macro drivers that point to the growing risk of a reversal ahead of key data and central bank meetings next week.

Energy, Fed pricing and fiscal nerves hit Treasuries

As seen in the graphic below, it’s been a tough time for bond bulls over the past couple of weeks. There have been a number of factors behind the lift in yields, although surging crude oil prices and downstream distillates have only helped fan inflationary concerns, especially with some evidence in the US August producer price inflation report released overnight suggesting there may already be some pass-through into consumer-facing categories.

Source: LSEG

That has seen expectations for a Fed rate increase in September lift to around 70%, with more than 40bp of hikes now priced by the end of this year, adding further pressure across the curve.

Donald Trump did nothing to stop the rot, pledging to pay every American adult a $5,000 “Trump dividend” if Republicans retain control of Congress following November’s midterm elections. The optics were absolutely terrible, coming only hours after the US Treasury had announced larger bond buybacks.

Even though we saw a strong 30-year bond auction during the session, with record-low dealer participation and the auction stopping through, any optimism from that result was quickly washed away by news that the first increased buyback operation from the US Treasury for 10 to 20-year debt came in at just over $5 billion, below the $6 billion ceiling that had been slated.

When you throw in hawkish comments from ECB President Christine Lagarde following the bank’s 25bp increase at its September policy meeting, including higher inflation forecasts, it proved to be a potent mix for a bond bloodbath.

A rare spread widening event

While the bond market is sending a clear message to the government that it does not like what it’s seeing, the surge in US yields has counterintuitively provided the kind of backdrop that would normally be supportive of gains for the dollar against the Japanese yen.

However, as seen in the graphic below, the pair’s recent performance has been highly unusual. Over the past five sessions, US-Japan spreads across the 2, 5, 10 and 30-year tenors have widened at a pace that sits around the 98.5th percentile going back to the late 1990s, making it a very rare widening event.

 

Source: LSEG

When you look back at comparable non-overlapping episodes, as you would expect, USD/JPY rose around four times out of five, with median gains of 1.3% over the same five-session window.

Instead, on this occasion, USD/JPY is down around 2.7% over the same period, putting the move roughly in the bottom 3% of comparable episodes.

So while widening spreads have become increasingly supportive for USD/JPY, those forces have so far been overwhelmed at a time when they would normally be in full swing. However, as the correlation matrix below shows, there is still evidence over shorter-term time horizons that the relationship between USD/JPY and movements in US yields remains intact

 

Source: TradingView

Yen tailwinds past the peak?

As discussed in a separate CHF/JPY analysis note on Thursday, while there are clear risks the US dollar may eventually weaken in an environment of mounting concerns around fiscal sustainability, the yen’s strength on this occasion looks at least partially artificial in nature.

While we’ve also seen notable hawkish repricing of the BOJ interest rate outlook, the more overwhelming force has arguably been record intervention from Japanese authorities, along with unusually heavy support from the US Treasury, especially Treasury Secretary Scott Bessent, who has essentially egged traders on to take him on in attempting to weaken the yen.

Bullish engulfing candle raises reversal risk

The question now is whether those forces can continue to overpower what has historically been a very bullish catalyst for USD/JPY. The price action on the charts raises serious doubts, with USD/JPY staging a significant reversal on Thursday, delivering a bullish engulfing candle that warns of reversal risk, particularly as it comes after a pronounced leg lower.

Source: TradingView

The level overhead to watch is 154.45, which has repeatedly acted as both support and resistance over the course of this year. While there was a failed probe above it on Thursday, the price now sits directly beneath the level, making it the one to watch when assessing whether to trust the bullish reversal signal.

If we see a push above 154.45, it would allow for longs to be established with a tight stop beneath for protection, initially targeting 155.50, a level that repeatedly mopped up offers earlier this year, including during two intervention episodes. A clean push above 155.50 would have bulls eyeing a potential retest of 156.68, the low set on August 7 that subsequently flipped to act as resistance earlier this month.

While the oscillators continue to favour bearish setups over longer time horizons, there is evidence that downside momentum may have already reached its crescendo. RSI (14) has moved out of oversold territory and is showing signs of starting to creep higher, while MACD is beginning to converge on the signal line while remaining in negative territory. It’s not a bullish signal, but at the same time it suggests the bears’ dominance may be slowly starting to turn.

If the pair remains capped beneath 154.45, the logical target would be a retest of the double bottom beneath 153, with 152.90 where the pair stalled on Tuesday.

While there are grounds to consider longs in this environment, the broader message still favours selling into strength, particularly with the key medium- and long-term moving averages rolling over quite sharply, along with the series of lower highs established since the multi-decade high set in July.

CPI looms as next hurdle

Of course, given the focus on bond yields and their historic linkages with USD/JPY, the August CPI report released later in the session will likely be highly important in determining how the pair fares heading into the Fed and BOJ meetings next week.

Any signs of heat, particularly in the core reading, which is expected to increase 0.2% from July, would likely solidify the market’s view that the Fed will lift interest rates next Wednesday. An inline reading or undershoot may provide a window for the Fed to reassess whether tighter policy is needed.

The CPI report, along with movements in crude and other energy markets, therefore looms as the key fundamental catalyst for anyone trading the pair on Friday.