FX.co ★ Farewell rally of USD/JPY: the dollar is pressing on the gas, but its running out of fuel

U.S. economic data breathed life back into the dollar, which has looked like a dying swan of late. However, many analysts believe that this growth momentum will not last long.

What's making USD upbeat?

At the start of the week, the U.S. currency showed gains across the board. The DXY index jumped 0.7%, showing the strongest momentum in 2 weeks.

The greenback's sharp recovery above the 105 level was due to stronger-than-expected U.S. macrodata.

The key report on Monday was the ISM services PMI. The index unexpectedly rose to 56.5 in November against the market forecast of 53.1 and the previous value of 54.4.

Dollar bulls were also happy with the data on manufacturing orders. The indicator rose 1.0% last month versus an expected 0.7% increase.

Reports showed that the U.S. economy is still showing some strength despite tighter financial conditions. This provoked another surge of hopes for a higher final level of interest rates in the U.S.

Recall that the other day Chicago Federal Reserve President Charles Evans also hinted at higher rates next year even if the central bank starts to slow the pace of tightening.

Market expectations for a less hawkish Fed rate hike have significantly grown after U.S. inflation declined more than forecast in October.

And so the dollar fell 5% against its major peers in November, posting its worst monthly performance since 2010.

Some analysts believe that the market has already fully considered the risk of a potential Fed reversal, and the topic has been completely worn out.

But now speculation is growing that the Fed 'pivot' narrative has run its course. "I think this issue about 'peak inflation, peak rates, peak dollar' - I think - is slowly turning into a 'persistence of inflation, a persistence of higher-for-longer interest rates," said Jane Foley, senior FX strategist at Rabobank.

Analysts at ING Bank predict that with prices rising steadily, there is a possibility that the Fed will maintain its hawkish narrative for longer. This should give the dollar a lot of support, especially in the areas where it has given up the most lately.

Recall that last month, the USD/JPY pair was the top loser among all dollar majors. The asset was down 7% in November.

However, yesterday this pair showed better dynamics. Amid widespread dollar strength, the quote rose 1.68%, rebounding sharply from Friday's low of 133.62 to 136.615.

Economists at TD Securities predict that USD/JPY could test the 140 level again before the end of the year. The catalysts will be the next increase in U.S. interest rates, which is scheduled for next week, as well as increased expectations of a higher peak in US rates.

Nevertheless, most experts are confident that this will be the last rally of the dollar-yen asset. A sharp change in trend is expected in 2023.

What will help the JPY?

The yen had the biggest loss of any Group of 10 currency this year. It has fallen in value against the dollar by 25%.

The main reason for such a dramatic drop of the JPY was the strong monetary divergence between the hawkish Fed and the dovish Bank of Japan.

However, now the JPY situation is starting to change for the better. Rising hopes that the Fed will slow the pace of rate hikes have helped JPY to rise by more than 10% from its October low.

Analysts are predicting a further recovery in the Japanese currency. The yen may gain more momentum as speculation over a potential BOJ monetary policy adjustment intensifies.

BOJ Governor Haruhiko Kuroda never tires of repeating the need to maintain an ultra-soft course in the country. However, his term in office will end in April 2023.

Economists believe that soon after his departure the central bank will begin to normalize its monetary policy, especially since further increases in inflation and wages are projected.

That view was voiced in an interview with Reuters academic Takeo Hoshi, who has close ties with current central bank policymakers. He said the BOJ may abandon its 10-year bond yield cap as early as next year on growing prospects that inflation and wages will overshoot expectations.

"The BOJ may give up control of benchmark bond yields within the next 3-6 months," analyst Sonal Desai supported his colleague. "That's when we will see a sharp decline in the USD/JPY pair."

Most experts also believe that it is only a matter of time before the only major central bank that still adheres to the dovish policy finally capitulates.

"At some point into next year then Japan justifiably will be hiking rates as well," said currency strategist Mark Nash. "Most likely, under pressure from high inflation, the BOJ will raise rates, which will lead to a strengthening of the yen to the level of 120," Nash said.

According to forecasts of Barclays and Nomura, in 2023, the yen may grow by more than 9%. And experts from Bank Vontobel believe that the fair value for the Japanese currency will be a level below 100. That is more than 35% above current levels.