USD/JPY continues to plummet as bears tighten their grip

USD/JPY continues to sink steadily, with no signs of reaching a bottom yet. Bears have firmly seized the advantage and show no intention of loosening their grip in the near future, particularly as the greenback faces the possibility of another devastating blow from weak US inflation data tomorrow. Let us find out the short-term and long-term downside risks for USD/JPY.

The hawkish policy of the Federal Reserve, which has been the main driving force behind the dollar's advance over the past 15 months, is nearing its end. Several American officials signalled it yesterday, triggering yet another USD drop.

At the end of last week, the greenback sharply fell across the board, following unexpectedly weak employment data in the United States. The nonfarm payrolls for June decreased significantly compared to the previous month, falling short of economists' expectations.

The pessimistic data had little impact on the market's expectations regarding the July FOMC meeting. Most traders still lean toward the view that the central bank will resume its tightening measures this month, potentially raising the interest rate by 0.25%.

However, in light of the recent employment data, many investors have started to seriously doubt the prospect of further rate hikes. Doubts have emerged whether anything will come after July.

The possibility of the Fed bringing its current tightening cycle to a close following the July meeting has put strong pressure on the US dollar. Last Friday, the greenback experienced a significant sell-off and suffered particularly large losses against the Japanese yen, dropping by 1.4%.

At the start of the new week, USD/JPY continued to fall. Yesterday, the asset lost 0.65% and closed at a monthly low of 141.31.

As mentioned above, remarks by Fed officials triggered the US dollar's latest decline. Last Monday, Loretta Mester, Mary Daly, and Michael Barr expressed the opinion that the US central bank would likely need to raise interest rates even higher to combat high inflation. These statements reinforced market expectations for July hike.

However, yesterday, FOMC members made surprisingly unanimous statements regarding the US central bank's future monetary policy. While they all agreed on the need to continue combating rising prices, each official emphasized that the current tightening cycle was rapidly approaching its end.

The market interpreted this rhetoric as dovish. Following the statements by Fed speakers, USD weakened across the board, including against the JPY. The Japanese yen received significant support from the potential narrowing of the interest rate gap between the United States and Japan.

There is now a high risk that tomorrow, investors' concerns about the upcoming easing of monetary policy in the United States will intensify even further. The release of the US CPI data for June, which is scheduled on July 12, could trigger it if the data is weaker than expected.

Economists predict that CPI declined in June to 3.1% YoY from 4%, reaching the lowest level since March 2021. They also expect core CPI to decline to 5.0% from 5.3%.

If the consensus estimates prove to be incorrect and inflation demonstrates resilience, it would provide the Federal Reserve with additional incentive to resume raising interest rates at its July meeting and continue with further tightening measures in the future.

In such a scenario, the dollar could regain some ground. However, according to many analysts, this is highly unlikely given the current strong disinflationary trends.

The risk balance for US consumer prices is currently tilted towards weaker data, particularly considering the ongoing decline in inflation related to housing.

If investors observe a significant downward trend in overall and core CPI, it is highly likely that they will revise their forecasts regarding rate hikes, both in the current month and in the more distant future. In this scenario, the US dollar is expected to drop even lower from its recent highs across all fronts, including against the Japanese yen.

According to the most pessimistic forecasts, USD/JPY bears might push the pair below the key psychological level of 140.00 in the short term, aiming for the Fibonacci retracement level of 50% around 139.60.

After that, the focus of bears will be on the 200-day moving average located around 137.20 and the January ascending support line at 134.90.

USD/JPY's situation is notably exacerbated by additional pressure from the Japanese front. Speculations regarding imminent changes in the BOJ's monetary policy resurfaced in the market last week.

With recent dovish comments from Japanese officials, traders are not holding high expectations for a complete hawkish turnaround and rate hikes at this stage.

However, there is an opinion that the BOJ may take a step towards normalizing its monetary policy as early as this month if it decides to adjust the yield curve control mechanism.

The Bank of Japan made changes to its Yield Curve Control (YCC) policy at the end of the previous year, when the local bond market was rattled by a wave of selling that resulted in a sharp surge in 10-year Japanese Government Bonds (JGB) yields.

Over the past few days, the yield on Japanese government bonds has once again started to rise steadily. The catalyst for this movement was the May wage data in Japan, which showed impressive positive dynamics.

Earlier, BOJ Governor Koji Ueda has repeatedly stated that wage increases are a key prerequisite for achieving stable inflation at the 2% target level. Such wage-driven inflation is, in turn, a vital trigger for any adjustments to the central bank's accommodative monetary policy.

This week, the yield on Japanese government bonds jumped by 3 basis points and approached the established limit of 0.50%.

Many analysts predict that as the Bank of Japan's July meeting approaches, the yield may increase and ultimately break through the ceiling, prompting Japanese officials to expand the allowable range of bond yield fluctuations once again.

Economists at MUFG believe it is likely that the Bank of Japan will change the current structure of YCC at its July meeting. The anticipation of this decision will significantly hinder the upward momentum of USD/JPY in the medium term. If there is an actual change in the yield curve control policy, it could cause a major sell-off, potentially sending the pair down to 130. Investors would interpret the YCC adjustment as the beginning of a significant shift among the BOJ's top policymakers.