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US yields signal a top in the USDJPY

The market has been focused on the US inflation data and the Fed's monetary policy. Some market analysts are worried about a hard landing, a recession, and continued disruption to the markets. The recent drop in yields post the CPI print may not have been what everyone was expecting, and we could see an unwind of the recent trends in the US dollar crosses.

Forex Analysis

This week’s main event was the US CPI and now market participants are piecing together all the economic evidence together to try and work out what the Fed may do next and also what to expect for the rest of the year. The consensus is that inflation is not going to come down fast, but we may have just witnessed ‘peak inflation’. It is very little in the way of stimulus being prepared for and monetary policy is pivoted towards removing any spare capacity to reduce demand.

A lot of focus is now on the US 2 Year note yield as this is the yield that the Fed can affect the most. The bond market moves the fixed income yields from the benchmark out to the 30-year. Since December 2021 they have been indicating that they don’t believe that the Fed with its rate hikes will create long-term prosperity and we have seen the yield curve flatten and in some areas invert.

The Federal Funds Effective Rate lags the US 2-year yield, so from the above chart, we can assume that the Fed will move its bank rates higher over the course of the next 3 meetings. Fed Chair Powell and other FOMC members said this will be at 50bps at a time.

Following the latest CPI data from the USA, Germany, and the UK the benchmark yields have come off their highs as the market either decides they don’t believe there is much room for rate hikes and that they have priced in the moves already, or that the economic landscape is showing a problem ahead and that a move back into the risk-free safe haven of a government bond would be the best bet for now.

Since 2020 and the pandemic sell-off in all assets the USDJPY and US 2-year yield have had a relatively close relationship. Recently though, as can be seen in the chart above they have started to move in lockstep. The dip in the 2-year yield has also translated into a sell-off in the USDJPY. The question is whether the USDJPY is now going to move lower?

The bearish scenario is that as yields drop the yen does better and on a USDJPY chart that would look something like a double top forming as we have seen recently, a break lower, and then for that old support to act as resistance. This will be the place to take a short trade. However, price action is still above the 200-period moving average, so we could compress around these levels for a while and create a larger distribution pattern.

I personally find it hard to get short in any meaningful way, when the majority of retail traders are also thinking the same thing. The ActivTrades sentiment indicator shows that 75% of traders are currently trading as though this is a topping pattern. I would like therefore to see this cohort have their stops removed above that double top and then for the USDJPY to either continue in its uptrend towards 135, possibly 150. Or for the sentiment to shift to neutral, possibly bullish as they get stopped out, and then for the collapse in the US dollar as yields drop and the yen goes higher.