USD/JPY: BOJ not giving up on abolishing negative interest rate policy despite obvious risks

• USD/JPY has fallen 5 big figures from the recent highs on the back of narrowing yield differentials between the United States and Japan
• BOJ Governor Ueda continues to talk up the prospect of abandoning negative interest rates, despite obvious macro risks
• Movements in USD/JPY are likely to be driven by changes to the US rate outlook, rather than Japan’s

Bank of Japan (BOJ) Governor Kazuo Ueda is not giving up on normalising monetary policy despite significant uncertainty over the outlook for the Japanese and global economies, putting USD/JPY under modest pressure on what’s been an otherwise quiet session in Asia.

Speaking in front of Japan’s parliament, Ueda said the BOJ had several options to lift interest rates out of negative territory, flagging it may keep targeting the rate it applies to cash reserves placed at the bank by financial institutions or shift to a policy targeting the overnight call rate.

"We have not made a decision yet on which interest rate to target once we end our negative interest rate policy," he said.

The choice of wording – “once”, not “if” – suggests the BOJ remains committed to normalising policy, most likely around the start of the fiscal year in April. But with markets bringing forward the expected timing and scale of rate cuts from other major central banks, such a move would be incredibly risky, creating a scenario that could send the Japanese yen sharply higher against currencies of its major trading partners.

The risk of policy error and stronger JPY

For a bank attempting to foster inflationary pressures by growing the economy sufficiently to boost wage demands, such an outcome would be suboptimal. Japan’s economy is struggling even with ultra-easy policy settings, with the boost from exported inflation already fading fast both at the headline and underlying level. While some modest tightening of policy is expected next year, surely the risk is the BOJ will miss the window to lift rates.

Ueda, it seems, is not oblivious to the risks.

"The situation remains challenging, and it will become even more challenging towards the year end and next year," Ueda said.

US rate outlook to remain the driving force behind USD/JPY gyrations

Regardless of whether the BOJ attempts to normalise policy or not, the outlook for US interest rates will remain the main driving force behind fluctuations in USD/JPY, flowing through to interest rate differentials with Japan. With 130 basis points of rate cuts priced into the US yield curve over 2024, that has mechanically dragged 10-year US Treasury note yields down by more than 90 basis points from the recent highs, leaving the spread over Japanese government debt of similar duration at the lowest level since August.

Source; Refinitiv

US-Japan yield spreads compress sharply, weighing on USD/JPY

That compression has weighed on USD/JPY, seeing the pair fall nearly five big figures from the recent highs. But with reliable economic indicators such as the ISM non-manufacturing PMI still pointing to decent activity levels in the United States, is suggests a further compression in yield differentials may be difficult in the near-term in the absence of a hard landing for the global economy. Still, relative to where it was trading earlier this year with benchmark yield spreads around similar levels, it’s arguable there may be further downside in USD/JPY to come. In August, USD/JPY was trading in the low to mid 140s, not the 147 level it sits today.

Looking at USD/JPY on the daily, bulls and bears are battling it out for control around key uptrend support. Whoever gains the ascendency may provide insights on what trades may work better over a longer-term horizon. Right now, USD/JPY is sandwiched between horizontal support at 146.50 and the former uptrend, trading in a comparatively thin range. On the downside, a break and close below 146.50 may be the catalyst for a more meaningful leg lower, with 144.80 the first logical target. 142, with the 200-day moving average just above, may be the limit to downside in the near-term in the absence of a policy or negative economic shock. In contrast, topside levels are compressed thanks to the long period of sideways trade earlier this year – 147.50, 148.40 and 50-day moving average are the initial levels to watch.

-- Written by David Scutt

Follow David on Twitter @scutty