USD/JPY Weighed By Lower U.S. Interest Rate Expectations

USD/JPY

The Bank of Japan left their benchmark rate on hold this week at 0.1% as deflationary pressures persist. The central bank pledged last month to keep inflation above zero which would require leaving interest rates on hold for the foreseeable future. Policy makers are projecting that deflation could rein until 2012 which raises the possibility of further easing. Therefore, U.S. interest rate expectations have begun to drive price action for the USD/JPY explaining 34% of volatility, as markets have begun to price in the expected spread in yields. Although the Fed is far from tightening, markets are still pricing in 68 bps worth of rate hikes over the next twelve months. As the dollar starts to lose its status as a funding currency, the pair has seen its positive correlation with risk return.

BoJ Interest Rate Expectations

Overnight Index Swaps are pricing in one bps of tightening over the next twelve months as there is little doubt that the BoJ will remain on hold. Upcoming CPI is expected to show that prices in January fell by 2.1%, slower than the 2.3% the month prior. Despite the expected improvement, inflation would remain well below zero percent. The central bank positively adjusted their inflation outlook for 2010 to -0.5% from -0.8%, and in 2011 from 0.4% to 0.2%. To discuss this and trading ideas join the USD/JPY forum.

FOMC Interest Rate Expectations

The FOMC reiterated their stance that they will keep rates on hold for an “extended period” despite an objection from Kansas City Fed President Thomas Hoenig. Despite the objection, interest rate expectations continued to fall with Fed fund futures now pricing in only a 16.4% chance of a rate hike. U.S. GDP figures are due for release tomorrow and forecasts are for a 4.7% rise which would be the most since the second quarter of 2006. Robust growth could raise inflation and interest rate expectations and could generate USD/JPY support.

Risk

Equity markets reversed earlier gains in the day as troubles in Greece, a rise in initial jobless claims, and disappointing durable goods orders helped generate bearish sentiment. Markets decided to ignore President’s Obama call for a new jobs bill and the allocation of $30 billion in TARP funds for lending to small businesses. However, a strong GDP print could reignite risk appetite as the additional stimulus may help sustain the recovery. Technically, we are seeing support from the 23.6% Fibo of 8087-10,729 which could lead to a retrace. However, a break below should lead to a test of 9,720-38.6% Fibo with possible support at 10,000. To discuss this and other fundamental data join the Economics Forum.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com