Typically, when risk assets rise, the USDJPY will follow suit. However, this time around, the EUR/JPY is not following a traditional relationship between risk assets and rate forecasts. This divergence from the norm is due to Japan’s economic recovery, which has weighed on the yen. It is therefore important to keep an eye on the PCE deflator – the Fed’s favorite inflation indicator – which will be released on Friday.
EUR/JPY has defied typical relationships with risk assets
The EUR to JPY currency pairing has a lot of cool stuff going for it. The two countries have a symbiotic relationship that stretches back over the last few decades. In the grand scheme of things, there are a number of ways in which the two sides could engage in a trade. Having said that, the two economies are at opposite ends of the economic spectrum. Fortunately, they both have central banks that have the requisite fiscal and regulatory systems to keep an eye on a problem that has afflicted the world on and off for too long. Despite the relative distance, the two nations have managed to maintain close ties with a plethora of bilateral trades and other formalities. It is this sort of cooperation that has spawned the ol’ fashion a few high flying acronyms in the middle of the pack.
Divergence in monetary policy settings in Japan and the US
The divergence in monetary policy settings between Japan and the US is now in full swing. While the Federal Reserve has been raising interest rates, the Bank of Japan is holding the line. This has sent the yen tumbling against the dollar. It is expected that the yen will weaken further as the autumn season unfolds in Asia.
The divergence is a result of the differences in economic recovery and monetary policy between the two countries. In the United States, President Donald Trump is proposing a lowering of the corporate tax rate to 20 percent from 35 percent. His proposed tax overhaul was unveiled on September 27.
In Japan, the yen is falling due to a widening gap in interest rates between the yen and the dollar. It is also due to the country’s reliance on imports, particularly of raw materials. Moreover, Russia’s war in Ukraine has pushed up raw material prices, leading to wholesale inflation in resource-scarce Japan.
Japan’s economic recovery has weighed down the yen
The economy of Japan has experienced a long and slow recovery from the pandemic and the currency crisis of 2011. However, the weak yen is weighing down the yen’s value and affecting the economic growth in Japan. It will dent the consumer spending. In addition, the weakness in the yen will increase the prices of fossil fuels, grains, and other import goods. This will affect manufacturers.
The Bank of Japan’s (BOJ) monetary policy remains ultra-accommodative. Low interest rates will continue to be maintained through 2022.
However, the yen is likely to remain under depreciation pressure until the end of the year. This will further affect the Japanese economy. Meanwhile, the Russia-Ukraine conflict is expected to exert greater depreciation pressure on the yen in the second half of this year.
PCE deflator – the Fed’s favorite inflation indicator – on tap Friday
Among the most important economic data of the week is the Federal Reserve’s preferred measure of inflation, the PCE deflator. Assuming no major surprises, economists expect the core measure to rise by 0.3% on a monthly basis. That’s a bit weaker than recent increases, but may signal that price pressures are easing.
Despite a decline in energy prices, the monthly gain was held back by a slowdown in vehicle prices. Consumer spending also did not rise after adjusting for higher prices.
While the Fed continues to hold out hope that price pressures will ease, the economy is still doing well with a low unemployment rate and a strong labor market. The Fed has taken several steps to boost growth in the past year. It raised the benchmark interest rate by three quarters of a point in March.
USDJPY is prone to further downside risk
The USD/JPY pair is an intriguing one to watch. Traditionally it has a strong correlation to US 10-year Treasury yields. In recent years, the yen has been favoring the dollar. This makes the USD/JPY pair a good speculative play. Its strength will depend on the economic outlook for both regions.
Despite the recent gains, the USDJPY is still in a bearish pattern. Traders are taking a wait-and-see approach before making any aggressive bets. If the Fed continues to hawk its ultra-loose monetary policy, the yen could find itself in a worse position than it was a few weeks ago.
A number of factors have been driving the USDJPY lower. One of them is the fact that the BoJ remains averse to a rate hike. During this cycle, the BoJ has been “printing” the yen, which is a policy of buying and selling government debt in order to keep interest rates low. However, if wages continue to rise, the BoJ may choose to tighten its monetary policy.