USD/JPY Fundamental Daily Forecast – Aggressive Fed Rate Hike Strategy Will Trigger Resumption of Rally

The Dollar/Yen is edging higher early Friday with the Forex pair turning higher for the week after a dismal two-day performance. The price action reflects position-squaring ahead of next week’s U.S. Federal Reserve monetary policy decisions on November 2-3.

This week, the Bank of Japan (BOJ) held policy steady as expected. Next week, the Fed is widely expected to announce it will begin tapering its massive stimulus. However, traders still aren’t sure what the Federal Open Market Committee will say about the timing of its first rate hike. This is one of the issues that could be the source of volatility next week. The other is the pace at which it will raise its benchmarks.

At 08:31 GMT, the USD/JPY is trading 113.677, up 0.124 or +0.11%. Last week, it settled at 113.495.

Some Investors Betting on Aggressive Fed Rate Hikes

Investors in U.S. interest rate options are paying for trades that benefit from a much earlier-than-expected monetary tightening by the Federal Reserve to fight off stubbornly high inflation, including multiple hikes from next year until 2023, Reuters reported.

The one-year forward rate on U.S. two-year swaps, that part of the curve most sensitive to rate hike expectations, on Thursday was implying a rate of 1.27% by October 2022, compared with the spot rate of 0.639%.

That forward rate suggests a more than 60 basis-point sell-off in U.S. 2-year swaps that pushes their rates higher, an ambitious outlook that suggested two rate hikes next year have been factored in, consistent with market expectations, analysts said.

“The sell-off in the front end is priced in very mechanically with the Fed,” said Bruno Braizinha, senior rates strategist, at BofA Securities in New York. “What the (swap rate) sell-off implies is a series of hikes that are getting front-loaded.”

Additionally, futures on the Fed Funds rate, which track short-term rate expectations, have fully priced in a quarter-point tightening by July 2022, factoring in another rate increase by December.

Near-Term Outlook

A hawkish Fed combined with this week’s dovish Bank of Japan monetary policy announcements should continue to underpin the USD/JPY over the near-term. The rally from the October 4 bottom at 110.826 to the October 20 top at 114.694 reflects the idea of a more aggressive Fed.

Since the Fed’s September 29 meeting, U.S. 10-year yields have risen more than 20 basis points, hitting a five-month high of 1.7% earlier this month. This move was driven by the Fed’s comments following the meeting. It said it would likely begin reducing its monthly bond purchases in November and hinted that interest rate hikes may follow.

Traders have priced in the tapering and perhaps a first rate hike. The recent price action in the Dollar/Yen reflects this. First the rally then the sideways price action.

If the Fed reveals a more aggressive rate hike strategy that hasn’t been fully-priced then we expect the USD/JPY to start another leg up once it clears the November 6, 2017 main top at 114.728.