Q4 2024 USD/JPY Outlook: Bearish bias on asymmetric US rates risk

USD/JPY key market drivers

To assess directional risks for USD/JPY, we need to determine what’s been influencing the pair recently. Based on the analysis below looking at the rolling 20-day correlation with a variety of financial variables, it’s obvious interest rate markets, especially in the United States, are important right now.

From top to bottom, it shows Fed rate cut pricing out to the end of 2025 in red, US-Japanese two, five and 10-year yield spreads in purple, green and blue respectively, US two-year yields in black and Japanese two-year yields in yellow.

As a reminder, correlation coefficient scores measure the strength and direction of a relationship between two variables, ranging from -1 to 1. A score of 1 means as one increases, so does the other, while -1 indicates that as one increases, the other decreases. The key thing to remember is the closer to either of the extremes, the stronger the relationship.

While Fed rate cut pricing has demonstrated a reasonable relationship with movements in USD/JPY over the past month with a score of 0.8, the correlation has been far stronger with yield spreads between two to five years.

US and Japanese two-year yields are evaluated separately to underline that it’s the US rate outlook that is strongly correlated with USD/JPY movements, not Japan’s.

That suggests if you’re trading USD/JPY, you need to be focused on the path of US rates in the absence of a weakening in the relationship.

Managing Q4 event risk

Armed with that information, you need to look at events that could alter the US rates outlook significantly over the coming months. Given the Fed has signaled its focus is now on the labour market, it’s easy to determine what data points are important.

Topping the list is non-farm payrolls reports which arrive on October 4, November 1 and December 6. They will be key, especially unemployment which we know the Fed does not want to see increase sharply. Speaking of the Fed, FOMC decisions arrive on November 7 and December 18.

They are the key data events to pencil in the diary.

However, I wouldn’t completely discount the relevance of inflation reports given how significantly they shifted the US interest rate outlook earlier this year. While the Fed’s preferred measure is the core PCE deflator, CPI reports have tended to be more impactful recently given they arrive earlier in the month. They hit on October 10, November 13 and December 11.

Outside those reports, the only others I’d put any weight on would be JOLTS job openings, weekly jobless claims, along with ISM services and manufacturing PMIs, especially the employment subindexes.

Outside data, the other major event is the US election on November 5. While major policy announcements involving significant expenditure could influence bond yields, unless there’s a clean sweep of both the house and senate by either party, the impact may be negligible given the likelihood of policy gridlock. If we do see a sweep, the risks for growth, inflation and size of the federal deficit would skew higher.

Expected path for Fed rate cuts

To get a sense as to directional risks for US yields and USD/JPY, it’s useful to know what’s priced in when it comes to Fed rate cuts.

The chart below does just that. Divided into three panes, the left looks at pricing for the November FOMC meeting, as derived from the futures curve, with the centre looking at pricing over the remaining two meetings in 2024. The right is pricing looking out until the end of 2025.

Traders do not expect the Fed to follow up the 50 basis point cut of September with another at either the November or December meetings, favouring 25-point moves at each. Where pricing starts to diverge is in 2025 where markets look for another 200 basis points of cuts, 50 more than what the Fed signalled in September.

Whether the Fed is forced to move towards the market or vice versus will likely heavily influence the performance of USD/JPY over the coming months.

US interest rate futures near key level

While the focus so far has been on drivers, event risk and market pricing, you shouldn’t discount the influence technicals may have on movements in short-end US bond yields. US Treasury note futures are among the most liquid futures contracts globally, meaning the price signals are arguably just as informative as fundamentals.

The chart below is the weekly two-year Treasury note futures contract. As a reminder, this is price, so if it’s moving higher, yields are falling. The opposite applies when the price is falling.

The price has been in a strong uptrend since the end of May, breaking through the highs set in January before successfully back testing the level. From there, it has moved up to test the next layer of resistance established in mid-2022. With momentum indicators such as RSI (14) and MACD continuing to generate bullish signals, you get the sense this is an important level not only for short-end US rates.

If the price breaks through, it signals another leg lower in US yields, likely placing downside pressure on USD/JPY given the close correlation between the two. But if resistance holds and price sideways range trades, it may provide an environment where USD/JPY could start drifting higher given it would imply the US is experiencing a soft economic landing.

Volumes have been strong recently, suggesting there’s no conclusive view on whether the Fed will be able to prevent a meaningful lift in unemployment.

Japanese rates a secondary consideration

As explained earlier, the Japanese yen side of the USD/JPY equation is nowhere near as important right now, hence it will not be a significant area of focus. But it’s worthwhile pointing out a few key things.

The first, hawkish language from Bank of Japan (BOJ) should not be deemed alarming or a surprise. Markets have around 20 basis points of further hikes priced in over the next 12 months.

The second is Japan’s inflationary pulse is already dimming with underlying measures converging back to or towards the BOJ’s 2% target. And that’s before the impact of recent yen strengthening filters through to imported inflation.

To be able to keep raising rates, the BOJ needs domestic inflation pressures to remain firm, putting emphasis wage and household spending. If strong wage increases can’t boost demand, it will be difficult for inflation to be sustained, or for the BOJ to continue hiking.

The final point is that when yield differentials between the US and Japan across multiple tenors are still measured in the hundreds of basis points, talk of the BOJ lifting overnight rates by 20 basis points over the next year rams home the point that it’s the US rates outlook that is primarily influencing yield differentials.

USD/JPY technical analysis

Looking at USD/JPY on the charts, there’s signs the bearish move from the multi-decade highs struck in July may be starting to stall with buyers emerging on moves towards and through 140.25, the low hit in late December 2023. At the same time, following the key bearish reversal in early September, subsequent rallies have stalled above 143.48.

While RSI (14) and MACD continue to deliver bearish signals on momentum, you get the sense further downside may be difficult if US economic growth holds up. But if it doesn’t, watch for a possible retest of the January 2021 uptrend and support at 137.70, a level the price respected regularly in 2022 and 2023.

If those levels were to give way, it would likely be in an environment of deteriorating US data and volatility in markets, putting 133.60, 129.65 and 126.70 into play. Below, there’s not a lot of visible support until 118.60 and 116.35, and they’re only minor levels.

Hard landing favoured, eventually

While this economic cycle has been difficult to pick, based on trends in US unemployment and underemployment, it looks like prior downturns when they were in their infancy. That warns of downside directional risk for US yields and USD/JPY ahead.

I’d ascribe a two in three chance of some form or hard landing, with the Fed having to respond aggressively. Another added layer of complexity is whether such a scenario plays out in the final three months of the year. It’s possible.

If unemployment remains capped at or below 4.4%, sideways range trade is favoured. Now the Fed’s easing cycle has begun, it will be very difficult to see the price revisiting the highs set earlier this year.

Each scenario and likely range are labeled on the chart for reference.

-- Written by David Scutt, Market Analyst

Follow David on X: @scutty