USD/JPY Forecast: Dollar needs a steeper yield curve

Omkar Godbole FXStreet Contributor

US 10-yr yield minus 2-yr yield & USD/JPY comparison chart

The chart above clearly shows the strength in the American dollar is clearly dependent on the performance of the 10-year yield curve. A steeper yield curve (a bigger rise in 10-yr yield) is positive for the USD and vice versa.

Fed rate hikes don’t yield a steeper yield curve

Fed has delivered two rate hikes in the last six months. However, the yield curve has flattened since the beginning of the year… mainly because the long-term inflation expectations dropped.

10-year breakeven rate (long-term inflation expectations) and US 10-yr yield minus 2-yr yield comparison chart

It is quite clear from the above chart that a steeper yield curve is dependent on long-term inflation expectations.

Thus, we can conclude that the fate of the US dollar is more dependent on the US consumer price index (CPI) due today at 12:30 GMT.

Watch out for a bull trap in the USD

The 25 basis point rate hike has already been priced-in by the markets. A minor spike in the USD cannot be ruled out if the Fed still sees a potential for one more rate hike in 2017. However, it could be a bull trap as the hawkish interest rate forward guidance alone may not yield a steeper yield curve.

As seen in the above charts, it is the rise in inflation expectations that could yield a steeper yield curve.

What else can yield a steeper yield curve & strong dollar?

The long duration yields could spike if the Fed details its intentions to unwind its $4.5 trillion balance sheet later this year. Fed would first stop reinvesting the proceeds of its bond holdings followed by off loading of its bond holdings. Both measures would tighten liquidity and boost long duration yields, leading to a strong US dollar.

USD/JPY Weekly chart

The weekly 50-MA has bottomed out and is now sloping upwards
Last week’s candle had a long tail, suggesting dip demand around 109.10 levels.
Thus, the pair looks set to break higher from the falling channel/flagpole pattern. The immediate resistance is seen at 111.59, ahead of 112.60 (weekly 100-MA).
A steeper yield curve after US CPI release and Fed rate decision could yield a sustained break above 111.59 levels.
On the other hand, a weaker CPI and a dovish Fed hike would open doors for a break below 108.13 (April low).

Author

Omkar Godbole

FXStreet Contributor

Omkar Godbole, editor and analyst, joined FXStreet after four years as a research analyst at several Indian brokerage companies.

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