Trade of the Week: Yen on high alert with BoJ decision looming

Brace yourself!

We could be in for the-most-volatile week for USDJPY since the onset of the Covid-19 pandemic, at least going by the 1-week implied volatility for this pair:

 

USDJPY: What could trigger this week’s big move?

All eyes are on the Bank of Japan (BoJ) policy meeting on Wednesday, even as December’s shocker rings fresh in the market’s minds.

Recall how, last month, the BoJ unexpectedly doubled the ceiling for 10-year yields up to 0.50%.

Such adjustments are widely seen as a precursor to the eventual BoJ rate hike, which markets expect to happen in April.

 

With all that in mind, here are 3 key things to look out for at this week’s BoJ meeting:

1. Rate hike?
   
   It’s unlikely (only a 21% chance, based on market forecasts), but the Japanese central bank could deliver a shocker of epic proportions if it decides to hike its policy balance rate, which currently stands at minus 0.1%.
   
    
2. Tweaks to policy language / inflation forecasts?
   
   The Yen is ready to react to any hints that the current BoJ Governor Haruhiko Kuroda may drop about potential policy adjustments by the central bank before he steps down in April.
   
   Also, the central bank is due to release its quarterly economic projections this week. If the latest forecasts for core inflation (excluding food and energy) shows that the BoJ's 2% target is drawing closer, that may invoke heightened market chatter than a BoJ rate hike will arrive sooner than expected, with such chatter likely to spur on further JPY gains.
   
    
3. Yields cap hike, redux?
   
   Markets are bracing for another yet another upward adjustment to Japan’s 10-year yields cap, just as it did last month.
   
   Such forecasts can be derived from how Japan’s 10-year benchmark yields have behaved in recent days, with traders even willing to challenge the new ceiling, sending yields past the 0.5% cap since this past Friday:

Note that, generally speaking, higher yields lend themselves to a stronger currency.

Hence, no surprise that these surging yields have helped the Japanese Yen take full advantage of the weaker US dollar, with the former being one of the best-performing G10 currencies against the greenback so far this year.

 

But be warned! The BoJ could disappoint.

Given the market’s aggressive expectations for another policy adjustment, should the BoJ stand pat this week, that could upset Yen bulls and prompt the unwinding of the Yen’s 2.2% year-to-date gains against the US dollar.

The BoJ may also be inclined to push back against market expectations, at least to “save face” and not give the impression that December’s adjustment was inadequate, with policymakers having to “catch up” with bond markets since its last meeting.

 

Potential scenarios for USDJPY

Here are the same scenarios for USDJPY as stated in our Week Ahead article published last Friday:

• If Governor Kuroda pushes back against the market’s expectations for a rate hike this year, that may prompt the Japanese Yen to unwind some of its recent gains and potentially pull USDJPY back above the psychologically-important 130 mark.
   
• On the other hand, should markets detect the slightest of hawkish hints (BoJ is getting closer to a rate hike) out of Governor Kuroda next (update: this) week, that should move USDJPY closer towards 126.0 and potentially test the lower downtrend line that began in November.

Going back to the 1-week implied volatility chart at the top of this article, it also suggests a 70% chance that USDJPY could this week reach either as low as 123.9, or back up as high as 132.4.

 

It may all boil down to the incoming BoJ policy signals, and whether the central bank leans into or against market expectations for more policy tightening to come.

 

Technical pullback?

However, looking at the chart below, USDJPY's 14-day relative strength index careened close to the 30 threshold which denotes "oversold conditions".

That may explain the pullback in this currency pair at the time of writing, as USJPY recovers from such oversold conditions.

However, once the froth is cleared, that may pave the way for the next big move for USDJPY over the coming days.

 

Also look out for: Japan national CPI (consumer price index) due Friday, January 20

The headline inflation print out of the world’s third largest economy is due before the weekend, and is forecasted to post a 4% print – its highest in over three decades!

BOJ Governor Haruhiko Kuroda has been willing to look beyond such elevated inflation numbers because he believes that the cost-push drivers are temporary. He wants to see more sustainable demand-pull inflation stemming from wage growth.

Still, a higher-than-expected CPI print may embolden those expecting the eventual BoJ rate hike to arrive perhaps as soon as Kuroda’s replacement takes the helm of the Japanese central bank in April.

The narrative above may boost the Yen’s fortunes further, even after its terrific start to the new year.

NOTE: Back on Jan 4, 2023, we highlighted JPY as one of the 3 potential winners of 2023, with USDJPY potentially dropping down to the 125 mark.