USD/JPY gripped by fear

The monetary policy divergence between the US and Japan continues to determine the performance of USD/JPY. Despite a substantial leap of over 2% in the preceding week, the pair started the current week on a quieter note. What did weigh down on the pair, and is there a potential for a sustained rally?

This month has witnessed a notable first from the Federal Reserve. For the first time since March 2022, the regulator has paused its aggressive rate hikes.

Such inaction could have spelled trouble for the US dollar if it weren't for the hawkish posture of US officials. Their projections of climbing interest rates successfully prevented a significant USD slump and effectively reanimated the currency.

Last week, Fed Chair Jerome Powell, did not dismiss the possibility of additional rate hikes. Instead, he reassured markets that he saw no grounds to reduce rates this year, as inflation is still trailing significantly behind the 2% target level.

In response to Powell's latest remarks, futures traders amped up their expectations of a 0.25% rate hike in July. Market players are now estimating a nearly 75% probability for this scenario, a stark contrast to earlier predictions foreseeing a halt in Fed rate hikes this year.

The prospect of sustained hawkish policy in the US provided strong support to the US dollar, particularly against the japanese yen. As June comes to a close, the latter faced another blow, as Japan opted for a contrasting stance.

In its June meeting, the Bank of Japan committed to its ultra-dovish policy, maintaining very low interest rates.

Moreover, several officials from the Bank of Japan clarified last week that the regulator's immediate plans did not include a normalization of monetary policy or rate increases.

Subsequently, market participants have reassessed their expectations concerning the trajectory of monetary policy in Japan.

Swap traders ramped up their bets last week that the Bank of Japan (BOJ) will stick with its dovish approach not just in 2023, but in 2024 as well

A month ago, swap market bets hinted at a possible end to the BOJ's ultra-soft policy in 2023.

"The market has been ahead of itself in expecting a hawkish BOJ move," Eiichiro Tani, chief strategist at Daiwa Securities noted. "That turns out to have been a mistake."

The current sentiment of traders aligns with the views of the majority of analysts. More than half of economists surveyed by Bloomberg expect the Bank of Japan to keep the negative-rate policy at least until the end of next year.

"Pressure is easing on Japan's central bank to change its policy framework, as the yield curve became less distorted, and indicators for its bond market such as trading volume and bid-ask spreads improved, and wage data showed continued weakness," Bloomberg's analysts noted.

The dovish outlook in Japan is an additional bullish factor for USD/JPY. As a resuly, the pair once again hit its seven-month high at 143.8 last Friday. However, it couldn't hold on to this peak due to an increased risk of monetary intervention from Tokyo.

This week, the dollar-yen pair has been trading within a bearish correction. Yesterday, the quote hit an intraday low of 142.93 before regaining lost ground and closing the session around 143.48.

A key trigger for the pullback were the ramped-up intervention warnings from the Japanese government. Yesterday, these warnings came from Japan's top currency diplomat Masato Kanda and the country's Finance Minister Shunichi Suzuki.

Both officials stated that Japanese authorities would react appropriately to further yen depreciation if currency fluctuations become too severe.

Last autumn, when the JPY also showed significant weakness against the US dollar due to the monetary policy gap between Japan and the US, the Japanese authorities intervened twice, which eventually resulted in USD/JPY dropping sharply.

The Japanese government first intervened in September when the yen fell against the dollar to 145.90, and again in October, when the JPY dropped to 151.90.

"We're entering the intervention levels that we saw in September and October," analyst Quentin Fitzsimmons said, noting that the Japanese authorities might switch from talk to action.

Currently, experts identify 145 and 150 being the red lines for the BOJ. USD/JPY is close to reaching the first level. However, the fear of intervention will likely limit dollar bulls' activity in the near future, despite potential triggers coming up tomorrow.

Speeches by BOJ chief Kazuo Ueda and his Fed counterpart Jerome Powell are scheduled for Wednesday. Both Ueda and Powell are likely to stick to their script, but are unlikely to intensify their previous rhetoric.

In the current scenario, with Tokyo again poised to hit the red button, it's unlikely to spark a strong upsurge for USD/JPY.

Analysts forecast that, in the short term, the dollar-yen pair will trade sideways. But by week's end, USD bulls might take the risk and charge if they get solid evidence that the Fed will not just raise rates once, but twice this year.

Doubts loom among market participants regarding the outlooks by US policymakers that indicate at least two more tightening rounds are coming in 2023. However, the sentiment could shift if hotter US CPI data, due out on Friday, paint a different picture.

Economists anticipate that the data release, which is a key gauge closely monitored by the Federal Reserve to shape its monetary policy, will remain unchanged.

Should inflation increase, it is likely to reinforce the market's belief that the US central bank has a protracted battle against inflation ahead.

In that case, the US dollar will get a strong boost, especially against the yen. Against this background, the temptation to go long on USD/JPY may well outweigh the fears of intervention.

If USD/JPY breaches 144.00 in the near term, bulls will set their sights on the key level of 145.10, the daily low of October 27, 2022, followed by the daily high of November 10 at 146.59.

The strong overbought conditions, coupled with signs of slowing momentum, suggest that USD/JPY could continue its pullback. Only a breakout below 142.30 would indicate that the USD rally, which began a week and a half ago, has come to an end.