USD/JPY Forecast: Downside calling as rally in 2Y yield spread stalls, demand for JPY calls rises

USD/JPY could be in for a deeper drop below the psychological support of 110.00.

At press time, the currency pair is trading at a 16-day low of 110.38, having dropped 0.7 percent yesterday.

The anti-risk JPY is solidly bid, seemingly due to rising trade tensions. Further, a better-than-expected US ISM non-manufacturing number released overnight failed to lift the treasury yields, making the pair more vulnerable to risk aversion.

The spot will likely remain under pressure ahead of the midnight tariff opening point - the US is scheduled to impose tariffs on $200 billion worth of Chinese goods. A surprise delay might put a bid under the pain, however, gains will likely be short-lived on fears that the US could soon impose tariffs on Japanese vehicles and automotive parts.

More importantly, the yield differential is biased toward the JPY bulls.

10Y spread

2Y spread

• The 10-year yield spread suffered a head-and-shoulders breakdown a few days ago, meaning it is more likely to narrow in the USD-negative manner in the near future.
• The two-year yield spread has not hit new post-GFC highs since the end of July and could roll over in the JPY-positive manner in the next few days.

Meanwhile, the implied volatility premium (or demand) for the out of the money JPY call options has hit three-week highs today. For instance, the USD/JPY three-month 25 delta risk reversals (JPY1MRR) are being paid at 1.775 JPY calls vs 1.35 JPY calls on Aug. 29.

JPY1MRR

The rising demand for the JPY call options indicates the investors are likely expecting a deeper drop in the USD/JPY pair.

And last but not the least, the long-term bullish outlook would be aborted if the pair finds acceptance below the psychological level of 110.00, a level where the long-term falling trendline is located.

Weekly line chart

A weekly close below 110.00 would neutralize the bullish outlook and shift risk in favor of a drop below 109.77 (Aug. 21 low). A daily close below that level would confirm a bullish-to-bearish trend change, that is, the rally from the March low of 104.63 has ended and would open up downside towards 108.90 (50% Fib R of 104.63/113.18).

On the higher side, 111.83 is the level to beat for the bulls.