USD/JPY: massive upsurge could be on horizon

The Japanese yen has apparently run out of steam after making large gains against the US dollar. Over the past 4 trading sessions, the Japanese currency lost about 1% and is about to end its 2-week winning streak. Meanwhile, analysts predict that USD/JPY could rally and skyrocket 2 weeks from now.

Last week, the US dollar suffered its biggest losses since November 2022, as weak inflation data reinforced trader expectations that the Fed is approaching the end of the current tightening cycle.

Currently, most investors expect the US central bank to hike interest rates once again next week, but this move is widely believed to be the last hawkish action by the Fed this year.

This will be a highly unfavorable scenario for the greenback, but dollar bulls are not planning to throw in the towel. This week, bullish traders have returned to the market and pushed USD up substantially.

Since Friday, the US dollar index (DXY) went up by 1% against a basket of major currencies. Investors are now increasingly hopeful that the Federal Reserve will keep interest rates high for a long period of time, which drove the index upwards.

Now, USD bulls are afraid of the easing of monetary policy in the US. However, persistent inflation, a strong labor market, and a robust state of the economy could prevent the Fed from carrying out a U-turn in the short term.

According to the latest data, US CPI slowed down to 4% from 4.9% in June, but inflation remains above the Fed target level of 2%. This suggests that the hawkish stance needs to be maintained at the very least, if the cycle cannot be continued.

Yesterday, investors received further evidence supporting this optimistic theory. The weekly report by the US Labor Department showed a sharp decline in the number of initial jobless claims.

Jobless claims amounted to 228,000, below the economists' forecast of 242,000. It hit the lowest level in two months.

As we can see, the US labor market continues to demonstrate resilience in the wake of the previous rounds of Fed tightening. This is reinforcing market expectations for a July rate hike and weakening speculation about an imminent easing of monetary policy in the US.

According to analyst Adam Button, the latest data once again highlighted the fact that the labor market in the United States is exceptionally robust and that the Federal Reserve still has significant work ahead of them.

Meanwhile, some experts now do not rule out the possibility that next week, the Fed could hint towards an additional rate hike in September.

If the possibility of such a move is confirmed by Fed Chair Jerome Powell on Wednesday, July 26, it could be a strong bullish factor for the US dollar.

Over the next few days, the greenback may experience extreme upward volatility across the board, particularly against the Japanese yen.

Over the past two weeks, the yen has gained more than 3% against the US dollar. However, it came under sellside pressure once again at the end of this week.

JPY was undermined by weakening market speculation about changes in yield curve control policy at the July meeting of the BOJ, which will be held next week.

Until recently, many investors were actively betting that the BOJ would take its first step in a hawkish direction this month by adjusting the YCC. However, these illusions were almost completely dispelled this week by a dovish speech from the head of the BOJ.

Last Tuesday, Kazuo Ueda said that the central bank is still a long way from achieving its main goal of maintaining inflation at a steady level of 2%, which is necessary for monetary policy normalization to begin. He stressed the BOJ's intention to stick to the present policy course.

This resulted in the yen falling by nearly 1% against the dollar. By the end of the week, USD/JPY consolidated above the key level of 140, although it was testing lows around 137 a couple of days ago.

Even today's inflation data, on which yen buyers had high hopes, did not help the Japanese currency. Yen bulls expected consumer prices to rise more sharply in June, but the actual data showed that inflation growth was moderate, reinforcing the market's dovish sentiment.

Last month, the nationwide core consumer price index rose to 3.3% from 3.2%, which was in line with economists' preliminary estimates.

The real surprise for traders was the CPI slowdown, which takes into account energy prices. The indicator, which is closely watched by the Bank of Japan to determine trend inflation, fell to 4.2% from 4.3%.

Carol Kong, a currency strategist at Commonwealth Bank of Australia, stated that the prolonged price pressure driven by the rise in commodity prices may have reached its peak. In such a scenario, the Bank of Japan does not currently have significant arguments in favor of tightening its policy. The CBA's baseline forecast suggests that the BOJ will maintain its current monetary stance unchanged throughout 2023.

Toru Suehiro, chief economist at Daiwa Securities, predicted that inflation will likely slow down in the coming month, and that Japanese CPI will fluctuate near 1%, below the target level set by the BOJ.

With core inflation still gaining momentum, many market participants expect the regulator to raise its estimate to 2.3%, especially given that yesterday the Japanese government raised its overall inflation forecast for the current fiscal year to 2.6%.

Most analysts believe that raising the inflation outlook is unlikely to prompt the BOJ to modify its yield curve control mechanism at this stage, when the local bond market is functioning normally.

If the BOJ does indeed fail to carry out the long-awaited YCC adjustment in July, it could dramatically weaken the yen against the US dollar.

According to the most pessimistic forecasts, JPY is at risk of returning to its recent lows around 145 in the medium term.

In the absence of any significant data releases in the US and Japan early next week, USD/JPY traders are likely to refrain from placing aggressive bets ahead of key Fed and BOJ meetings. The pair will trade sideways on Monday and Tuesday.

The Fed is expected to announce its interest rate decision on Wednesday. On that day, the US dollar may rise sharply if the Fed Chairman's rhetoric is more hawkish than expected by the market. Conversely, the dovish tone of the Fed Chairman will deal a crushing blow to the greenback.

The Bank of Japan will announce its decision on Friday. If it does not initiate any changes and signals a long-term accommodative policy, it will send the yen into a free fall and accelerate the rise of USD/JPY. Conversely, a hawkish surprise from BOJ, which is now seen as unlikely, could send the Japanese currency into a rally.