USD/JPY Fundamental Daily Forecast – Easing US Inflation Won’t Alter Fed’s Rate Hike Plans

The Dollar/Yen is inching lower early Wednesday as investors await the release of the U.S. consumer inflation report at 12:30 GMT. The report is expected to show that U.S. consumers finally received a break at gas pumps and the dinner table, although non-seasonal items likely drove core inflation higher.

The headline consumer price index (CPI) is expected to have risen 0.2% in July from a month earlier, which would be the smallest advance since the start of 2021. However, core inflation, which strips out energy and food, probably climbed a worrisome 0.5%, based on a consensus of estimates.

At 05:04 GMT, the USD/JPY is trading 135.003, down 0.135 or -0.10%. On Tuesday, the Invesco CurrencyShares Japanese Yen Trust ETF (FXY) settled at $69.18, down $0.06 or -0.09%.

While moderation in the broad-based headline number will likely be considerably noted by the Biden administration, the pace and breadth of inflationary pressures remains strong, which means more pain for the consumer.

This is because the combination of the surprisingly strong July jobs report that included a larger-than-forecast increase in average hourly earnings and inflationary pressures should keep Federal Reserve policymakers on course for additional super-sized interest rate hikes.

With the Federal Reserve expected to continue to make hawkish moves, and the Bank of Japan likely to remain dovish, the advantage is still with the U.S. Dollar although we could see some volatile price action over the next several weeks.

More Volatility Ahead

Rising Fed rate hike expectations will drive the USD/JPY higher, but only to the extent they put upside pressure on Treasury yields. In other words, if Fed rate hike expectations rise and Treasury yields rise then look for the U.S. Dollar to rise against the Japanese Yen.

But Treasury yields could fall if other economic reports continue to point toward an economic slowdown or recession. If the odds of a recession rise then Treasury yields could retreat which would weaken the Dollar/Yen.

Short-Term Outlook

On paper it seems easy, Fed raises rates, Treasury yields rise, Dollar strengthens, but it’s not going to be that easy because as the Fed moves to drive down inflation, it will also weaken the economy. As the economy weakens, traders will start to price in a slower pace of Fed rate hikes. This is going to trigger a volatile response in the market.

To put it another way, the USD/JPY could continue to climb if the Fed keep front-loading supersized rate hikes, but if the economy weakens too much then the pace of the rate hikes will slow and the Dollar/Yen will weaken.

Since the Bank of Japan is not expected to make any changes to its ultra-dovish policy, all of the price action in the USD/JPY will be determined by the interest rate differential between U.S. Government bonds and Japanese Government bonds. The movement in the differential will be data dependent.