USD/JPY weekly outlook: US inflation threatens to break the stalemate

• US CPI and PPI headline a packed inflation calendar
• Markets price three-plus Fed hikes despite recent disinflation
• Short-term correlations suggest risk appetite is driving USD/JPY
• Narrowing trading range leaves USD/JPY awaiting a catalyst

US inflation data dominates the week ahead for USD/JPY, with Wednesday's CPI and Thursday's PPI reports likely to influence Treasury yields and broader risk appetite.

With markets pricing more than three Fed rate hikes by the middle of next year, the onus remains on inflation to stay relatively elevated and sticky to justify those expectations.

However, the recent deterioration in USD/JPY's traditionally strong relationship with US Treasury yields suggests the reaction in riskier assets may be just as important as movements in yields themselves, complicating the outlook for the pair.

US inflation takes centre stage

Source: TradingView

Outside Wednesday's CPI report, Thursday shapes up as another big session for US economic data, with PPI and retail sales released alongside each other. Following strong increases across retail sales measures in August, another solid outcome would reinforce the view that consumer demand remains firm enough to support further Fed tightening.

Friday's import prices will also be worth monitoring for signs of inflation pressures, particularly given elevated energy costs.

There's plenty of Fed speak throughout the week, although remarks after the inflation reports are likely to carry more weight. Governor Christopher Waller will discuss artificial intelligence at the Bloomberg New Economy Forum in New Delhi on Tuesday, while Fed Chair Kevin Warsh will participate in a fireside chat with IMF Managing Director Kristalina Georgieva in Bangkok on Thursday.

While Warsh may face questions about the policy outlook following CPI, he's shown little inclination to provide explicit forward guidance, and that's unlikely to change when discussing the global economy at a forum outside the United States.

In Japan, the calendar is as quiet as a church mouse. Remarks from BOJ board member Junko Koeda provide an opportunity to influence market pricing, which, like the Fed, favours a December move over October. Unless she delivers something truly unexpected, her appearance may come and go with little fanfare.

Core CPI cools, PPI remains hot

Heading into the September CPI report, the brutal truth is that inflation has remained above the Fed's 2% target for more than five years.

While there have been encouraging signs of near-term disinflation, with core CPI running at an annualised pace of just 1.97% over the past three months, the six-month annualised rate of 2.57% and year-on-year rate of 2.45% show that price pressures remain elevated.

Source: LSEG

For September, headline CPI is expected to rise 0.6%, with core inflation forecast to increase by just 0.2%, down from 0.3% in August.

Core PPI inflation has been running considerably hotter than core CPI, with the three-month annualised rate at 3.36%, the six-month rate at 3.73% and the annual rate at 4.62%.

However, historical analysis dating back to 2010 suggests that while producer inflation has traditionally provided some indication of where consumer inflation may be heading, that relationship has weakened considerably since 2023. More recent predictive testing also suggests PPI has generally made short-term CPI forecasts less accurate, rather than improving them.

While PCE remains the Fed's preferred inflation measure, historically it's been CPI that's generated the larger market reaction in Treasury yields and USD/JPY. That makes Wednesday's report the main event risk, with Thursday's PPI likely to play a secondary role, even though components feed directly into the core PCE deflator.

Three hikes priced, plenty at stake

As covered extensively beforehand, there's been an abrupt shift in the Fed interest rate outlook over the past six months, with markets moving from pricing several cuts to more than 80 basis points of tightening by the end of next year.

While there's little expectation of a follow up hike in October following September's increase, markets favour a further 25 basis point move before year-end, followed by at least two, perhaps three, more by the end of 2027.

Source: TradingView

Given how little tightening is priced for October, it would likely take a core CPI reading well north of 0.3% to get markets seriously considering a hike. Otherwise, recent Fed commentary suggests October is being positioned as a placeholder, with December the more likely live meeting when fresh forecasts and dot plot will be issued.

Alternatively, an undershoot in core CPI could pull the rug from underneath hawkish pricing, especially given the softness in payrolls a fortnight ago, potentially dragging Treasury yields lower, particularly at the front end and belly of the curve.

Risk appetite may matter more than yields

While the inflation reports will be influential for Fed pricing, particularly at the front end of the Treasury curve, the more important factor for USD/JPY this week may be how riskier assets digest those releases.

That's because the traditionally strong, positive relationship between USD/JPY, US Treasury yields and US–Japan yield spreads has been inconsistent recently. Over the past five sessions, USD/JPY has shown a correlation of -0.93 with VIX futures and +0.79 with S&P 500 futures, compared with just +0.47 for US two-year Treasury yields and +0.48 for equivalent yield spreads.

Source: LSEG

Over the past fortnight, correlations with US two-year yields and equivalent yield spreads have turned negative at -0.43 and -0.39, respectively, possibly reflecting the influence of quarter-end capital flows.

However, the strong relationships with VIX and S&P 500 futures are largely absent over longer windows, putting a big asterisk next to the recent readings. Five sessions is nowhere near long enough to declare a regime change, especially given the historical influence of interest rate differentials and carry trades.

While risk appetite has played a greater role recently, I suspect rate differentials will reassert themselves as a more influential driver of USD/JPY, particularly if this week's inflation reports trigger a meaningful shift in the Fed rate outlook.

USD/JPY playing pong between moving averages

Source: TradingView

For all the discussion about USD/JPY's changing relationships with yields and risk appetite, the pair has barely moved in October, trading in a range of roughly 150 pips. It feels like the market is waiting for a catalyst.

The broader range between 156.40 and 159.00 has been narrowing, with dips towards 157.50 bought last week, while offers continue to cap moves above 158.45.

As the daily chart inset shows, the latter sits just below the 200-day moving average at 158.54, while the 50-day moving average at 157.70 helps explain the dip buying. For now, USD/JPY is effectively playing pong between these moving averages.

Momentum indicators are providing no strong tell when it comes to directional bias. RSI (14) is marginally above the neutral 50 level but flatlining, while MACD has just crossed above its signal line in positive territory, although there's little velocity behind the move. Both are effectively meandering.

On the upside, 158.45 and the 200-day moving average at 158.54 are the initial levels to watch, followed by 159.00 and 159.50, where horizontal resistance converges with the 100-day moving average. The latter has acted as both support and resistance previously, strengthening its significance.

On the downside, 157.50 is the first level to watch following last week's dip buying, followed by 157.00 and 156.40, which has acted as both support and resistance recently. Below that, a more substantial support zone runs from 155.50 down to 155.00.

The threat of intervention remains a consideration on any sustained push higher. At the same time, the US economy continues to look a better bet than most, deterring prolonged dollar weakness.

For now, it's a stalemate. Perhaps this week's inflation reports will finally shake things up.