US Dollar Outlook: USD/JPY Hinges on Treasury Yield Volatility
USD/JPY PRICE OUTLOOK: TREASURY YIELDS TO GUIDE THE DOLLAR-YEN
- USD/JPY price action jumped by about 80-pips last week as Treasury yields climbed
- Broad US Dollar strength was ignited by red-hot inflation data and Fed taper fears
- Eurodollar futures currently price an 80% probability of a FOMC rate hike next year
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The US Dollar accelerated sharply higher in the middle of last week as Treasury yields spiked on the back of hotter-than-expected inflation data. US Dollar strength was felt against the Japanese Yen in particular due to the inherent sensitivity that USD/JPY price action has to changes in interest rates. Even though the broader US Dollar Index (DXY) surrendered most its gains during the latter half of the week, which was primarily driven by EUR/USD and GBP/USD rebounding, USD/JPY was able to muscle its way 80-pips higher on balance to close out at five-week highs. This followed a 4-basis point rise in the ten-year Treasury yield to 1.63%.
USD/JPY PRICE CHART WITH TEN-YEAR TREASURY YIELD OVERLAID: DAILY TIME FRAME (21 DEC 2020 TO 14 MAY 2021)
As illustrated on the chart above, there tends to be a strong direct relationship between USD/JPY and Treasury yields. USD/JPY price action thus has potential to extend its ascent if bond bears remain fearful of inflation and continue guiding Treasury yields higher. On the other hand, with the Federal Reserve sticking to its transitory inflation narrative and accommodative monetary policy stance, there has been some evidence of demand for Treasury bonds offering higher coupons. This stands to create headwinds for both Treasury yields and the Dollar-Yen. Correspondingly, I would have Treasury bond yields and gauges of Fed taper risk near the top of my radar for potential bellwethers to where USD/JPY price action might head next.
US DOLLAR, TREASURY YIELDS TRACKING INFLATION & FED TAPER RISK
One way to track market expectations for a Fed rate hike is by looking at Eurodollar futures. The price of a Eurodollar futures contract is calculated as 100 minus the three-month US Dollar LIBOR. As such, a lower Eurodollar futures contract price indicates that interest rates are moving higher, and vice versa. The December 2020 Eurodollars future contract, for example, currently trades at 99.59. This is down from a high of 99.64 last week, which reflects interest rate futures trader speculating on the Fed potentially having to expedite their taper timeline. That also means Eurodollar futures traders are now pricing about an 80% chance that the Fed will raise interest rates by December 2022.
By contrast, as detailed in the most recent summary of economic projections, only four FOMC officials penciled in a rate hike next year out of 18 total observations. And to be fair, the Federal Reserve has clearly communicated that markets should expect an acceleration in price pressures this year. The central bank also noted how it is willing to ‘look-through’ these temporary increases in inflation largely driven by base effects and supply chain bottlenecks. Fed jawboning may be able to alleviate some of the downward pressure on Eurodollar futures, which could explain the pullback in Treasury yields from 170-basis points. If markets continue to call the bluff, however, Eurodollar futures might gravitate lower and steer Treasury yields back higher. The latter, in turn, would likely fuel a broadly stronger US Dollar and bid beneath USD/JPY price action.
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