19.06.202310:07 Forex Analysis & Reviews: USD/JPY to continue its rally?

Over the past week, the USD/JPY pair performed a stunning rally, propelled by the hawkish stance of the Federal Reserve and the dovish decision by the Bank of Japan. Will the major currency pair maintain its rally in the coming days and what are the prospects?

USD spreads its wings while JPY drops

The USD/JPY pair jumped by 1.4% last week. The surge was stimulated by fears about the increasing divergence in the monetary policies of the US and Japan.

At its latest meeting on Wednesday, the Federal Reserve paused its tightening cycle after 10 consecutive rate hikes but signaled further possible increases.

The updated dot plot, which reflects individual expectations of Fed policymakers, revealed their hawkish stance despite the inflation slowdown and the risk of a recession.

According to their assessments, the US benchmark interest rate could increase by 50 basis points, reaching 5.6% by the end of the year. This projection surpasses previous forecasts, which had indicated a value of 5.1%. In light of this data, futures traders have significantly increased the likelihood of the Fed resuming tightening measures and raising interest rates by 25 basis points next month, with the probability of such a scenario now exceeding 70%.

The prospects of aggressive monetary policy in the United States provide favorable conditions for the strengthening of the US dollar, acting as a negative factor for its rivals. However, the Japanese yen is particularly at risk as it remains under the pressure of the Bank of Japan's ultra-loose policy.

In the previous week, the BOJ added fuel to the fire with its dovish decision. Following the June meeting on monetary policy, the regulator maintained negative interest rates at -0.1% and made no changes to its yield curve control policy.

Consequently, the yen reached a seven-month low against the dollar, trading at 141.88. On Friday, the JPY fell by more than 1%, marking the largest daily drop since April.

The yen came under more pressure as the Bank of Japan once again confirmed its view that the country's high inflation is temporary, and price growth is expected to slow down this year. This has significantly weakened market speculations about a possible monetary policy reversal by the Japanese central bank in the near future.

At this stage, most analysts do not anticipate any changes in the BOJ's current monetary policy throughout the year. While there remains a possibility that the Bank of Japan may adjust or abandon its yield curve control mechanism, interest rates are likely to remain negative, according to strategists at the Bank of Singapore.

The BOJ's commitment to its dovish stance will act as a tailwind for the USD/JPY pair, alongside the aggressive actions of the Fed.

Analysts at SocGen believe that if another interest rate hike occurs in the US in July, the USD/JPY exchange rate could rise to 145.

Short-term outlook for USD/JPY

This week, traders' attention will be focused on the speech by Federal Reserve Chairman Jerome Powell in the US Congress. He will present the central bank's semi-annual report on monetary policy to the House of Representatives on Wednesday and to the Senate the following day.

Democrats may support the Federal Reserve for taking a pause and remind Powell that excessive interest rate hikes could leave millions of Americans unemployed.

On the other hand, Republicans are likely to take the opposite position and insist on the need to continue tightening, citing the still-high inflation that continues to hurt ordinary Americans and small business owners.

In any case, both sides are likely to demand clearer prospects for further US monetary policy from Powell. The direction of the US dollar in the near future will depend on what stance Jerome Powell shows at this meeting.

"Powell has another opportunity to convince the markets that he is not a hidden dove, but it will be more challenging after the June pause. The fact that the FOMC did not raise rates, despite the regulator sharply revising its inflation and economic growth forecasts, suggests that American policymakers are either more tolerant of high inflation or simply unsure of the economy's sustainability," Bloomberg states.

If the Fed Chair gives clear hawkish hints this week, the greenback will strengthen across the board, with the USD/JPY pair being the main winner.

Since the pair is moving upwards, the first key level is seen at 142.00. Breaking through this level should open the way to the high of 142.24 recorded on November 22.

If the pair manages to reach this high and consolidates above it, it may then head for the October 2022 high at 145.10.

However, if Powell continues to emphasize the need to carefully study incoming data to make further decisions during his congressional speech, it could be interpreted by the market as a dovish signal.

The cautious stance of the Federal Reserve's chairman at this stage, when the regulator has already taken a timeout, is likely to raise doubts about the rate hike in July. In such a scenario, the dollar risks falling in many directions, including against the yen.

In the worst-case scenario, USD/JPY could decline to the 20-day exponential moving average (EMA) at the level of 139.40.

In addition to Powell's speech, USD/JPY traders will pay attention to the May data on the number of building permits issued in the US, which is due on Tuesday, as well as the US Department of Labor's weekly report on unemployment claims, which will be released on Thursday.

On Friday, the key trigger for the dollar/yen pair should be Japan's inflation data for May. Inflation is expected to cool down from the previous reading, indicating a further slowdown in prices.

Currently, economists anticipate a decrease in Japan's annual inflation in the previous month from 3.4% to 3.1%. If their forecasts are accurate or if we see an even sharper decline in the pace of price growth, it will strengthen the market's dovish expectations regarding the Bank of Japan's (BOJ) future monetary policy, putting significant pressure on the yen.