The two main events on Thursday for currency markets will center on major central bank decisions from the European Central Bank and Bank of Japan. Both of these events have the potential to make significant impacts on their respective currencies – the euro and yen.
While expectations for the ECB are somewhat mixed, consensus expectations for the BoJ are substantially more one-sided. Perhaps the likeliest scenario for the BoJ is that the central bank keeps its policy unchanged as widely expected, and lowers its inflation forecast for both this year and next year. If BoJ officials then go on to suggest that the central bank’s 2% inflation target will not be hit, or that there may be a lengthy delay in achieving that target, the yen could take a significant hit.
As it currently stands, the Bank of Japan has become rather lonely in its prolonged dovishness. The BoJ’s inability to reduce its massive stimulus program or follow other major central banks in pursuing a tighter policy path can be attributed in large part to very weak inflation in Japan. This situation is not likely to end any time soon, which accentuates the growing policy divergence between the BoJ and most other major central banks.
Despite the recent dovish turn by the US Federal Reserve, as Fed officials have begun to discourage speculation that US interest rates will continue to rise much further, the policy divergence between the Fed and BoJ continues to remain clear. And although US inflation has also shown some recent weakness, it is nowhere near the sluggishness of Japanese inflation.
How might these conditions affect the Japanese yen? The persistence of very low inflation in Japan and growing policy divergence between an enduringly dovish BoJ and its significantly more hawkish counterparts – including the Fed – have the clear potential to weigh increasingly on the yen. In the absence of any surprises from the BoJ on Thursday, the yen may fall once again as this policy divergence is underscored. After a prolonged period of weakening, the yen has seen a modest relief rebound that began last week. In combination with a pressured US dollar, this yen rebound helped push USD/JPY below the key 112.00 level as of Wednesday. If the BoJ delivers a dovish statement on Thursday, as is likely to be the case, resulting pressure on the yen could push USD/JPY back up. This could especially be the case if the recently well-oversold dollar stages an overdue relief rebound. In such an event, a move back above 112.00 could prompt the currency pair to begin targeting key upside resistance at 115.00 once again.