USD/JPY Outlook: Risk Aversion Rises, Yen Gains as Trade War Erupts

• Trade war erupts up with new US tariffs sparking immediate retaliation
• USD strengthens, but yen rises on risk aversion
• Yen gains hint at carry trade unwinds
• NFP on Friday, but trade war headlines dominate

Summary

USD/JPY traders should brace for a week of headline ping-pong, with an escalating trade war between the United States and its major trade partners combining with traditional drivers such as interest rate differentials to dictate overall direction. That suggests incoming economic data and central bank commentary may take a backseat in terms of importance, though one event at the end of the week still carries the potential to generate a sizeable reaction given its implications for Federal Reserve policy settings.

Trade War Escalates, Volatility Spikes

Trump’s trade war has arrived with the United States slapping 25% tariffs on Canadian and Mexican goods imports, and 10% on those from China, starting Tuesday, February 4. The three targeted nations have already announced—or are contemplating—countermeasures of their own, risking further escalation from the Trump administration.

From hopes for no tariffs or staggered, smaller tariffs just a week ago, this marks a major escalation in trade tensions, raising the risk of slower demand and higher inflation the longer and wider the conflict becomes.

Navigating Headline Risk

The market reaction has been unsurprising to developments over the weekend, with the US dollar strengthening sharply against cyclical currencies such as the Australian and New Zealand dollars, as well as those from nations targeted or in the firing line for US tariffs, including the euro, Canadian dollar, and Mexican peso.

Without getting into detailed specifics, dollar strength reflects markets automatically beginning the adjustment process—weakening the currencies of nations targeted by the US to make them more competitive to counteract the initial impact on US demand. While a stronger dollar over time would help limit the overall inflationary impact in the United States, the potential for higher import costs to be passed on to end consumers has understandably placed upward pressure on Treasury yields.

Despite this, the Japanese yen is the only G10 FX currency to have strengthened against the US dollar in early Monday trade, hinting that risk aversion may be encouraging traders to begin unwinding carry trade positions where the yen was used as the funding currency.

If that trend persists, it points to asymmetric downside risks for USD/JPY: if the trade war de-escalates, the positive market reaction would likely be offset by lower US Treasury yields and a softer dollar. But if it escalates further, it risks sparking widespread carry trade unwinds, as seen in late July and early August last year, overriding the influence of widening rate differentials.

The point cannot be reinforced enough—developments in the trade war will almost certainly override any other market driver for USD/JPY this week. Traders need to be attentive to headline risk and may want to reassess trading timeframes, position sizing, and risk management to account for the volatile environment.

Yield Differentials Remain Key USD/JPY driver

Source: TradingView

As seen in the chart above, the influence of interest rate differentials and the US interest rate outlook on USD/JPY direction has strengthened recently, with the rolling 20-day correlation coefficient score with two-year (red) and 10-year (black) US-Japanese bond yield spreads rising to 0.78 and 0.84, respectively. Not quite lockstep, but a strong and strengthening relationship that should not be ignored. As shown by the score with Japanese 10-year bond yields (green), it remains the US rate outlook—not Japan’s—that dominate USD/JPY moves.

Armed with that information, traders can narrow down the known events likely to be important in the week ahead. Times shown below are JST.

Payrolls Headline Key Event Risk

Source: Refintiv

The main event is Friday’s non-farm payrolls report, with a particular focus on the unemployment rate and January payrolls change. While it has a bad reputation in some quarters, Wednesday’s ADP National Employment Report may offer clues on the pace of private sector hiring ahead of the official payrolls release.

Elsewhere, other events to watch include ISM manufacturing and services PMIs, the JOLTS survey, and the Treasury Refunding Announcement (Monday for initial borrowing details, Wednesday for specifics on debt issuance duration).

There are no scheduled events in Japan likely to generate volatility in USD/JPY.

Source: Refintiv

With the January FOMC meeting now in the rear-view mirror, Federal Reserve officials will be out in force this week with the media blackout period over. The key focus will be any remarks on the likely monetary policy implications of the trade war.

USD/JPY Neutral Near-Term Bias

Source: TradingView

Turning to the USD/JPY technical picture, the near-term bias is neutral. Momentum like as RSI (14) and MACD continue to trend lower, generating bearish signals However, three failed breaks beneath 154.00 last week, coupled with a topside break of the falling wedge pattern early Monday which points to the risk of a powerful bullish move given how long the price has been coiling within it, counteract the bearish momentum signal. 

If the price were to meaningfully break wedge resistance, topside levels of note include recent swing highs at 156.76 and 158.88. It would likely require a modest tempering of trade tensions to deliver such an outcome. However, if tensions were to escalate further, a bearish break beneath 154.00 would put 153.38 and key 200-day moving average on the radar. If the latter were to give way, there is little visible support evident until the December 2024 swing low of 148.65.

-- Written by David Scutt

Follow David on Twitter @scutty

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