USD/JPY Forecast: Most overbought since Dec 2016

Weekly chart

The USD/JPY is trading at a fresh six-month high of 112.76 in Asia, having cleared a key falling trendline resistance earlier this week.

A big move was expected as the volatility - the gap between the monthly Bollinger Bands - had hit an 11-year low earlier this week. However, the direction of the move is surprising as low volatility periods in the past have ended with a big move to the downside.

That said, the technicals were biased to the bulls - strong defense of rising trendline, a bullish outside-day reversal higher and pennant breakout (continuation pattern).

At press time, the currency pair is solidly bid and looks set to test the 200-week moving average (MA) hurdle, currently located at 113.23, but reckon the MA support would hold as the 14-day relative strength index (RSI) is standing at 75.50 - the highest level since December 2016, meaning the pair is most overbought in over 18 months.

Daily chart

The above chart shows RSI flashing overbought conditions

The bullish momentum is more likely to wane as the pair approaches the crucial 200-week MA hurdle. Thus, a break above the MA hurdle is unlikely to happen in the near-term.

That said, the probability of an aggressive move above the significant obstacle would rise substantially if the pair suffers a healthy pullback from the current levels. Moreover, traders who missed the big breakout this week would join the party on a healthy pullback, recharging engines for a convincing break above the 200-week MA hurdle.

The rally is not supported by yield differential

The USD/JPY pair has jumped more than 200 pips over the last three days, but the rally is not backed by a rising bond yield spread. For instance, the 10-year US-Japan yield spread has stagnated around 280 basis points. So, the rally looks unsustainable.

But then traditional Intermarket correlations have broken down this week and the JPY is largely taking cues from Chinese Yuan (CN) and other Asian currencies. However, CNY is flashing oversold conditions and looks due for a minor corrective rally.

Hence, USD/JPY could have a hard time scaling the 200-week MA in the short-run.

View

The currency pair is reporting overbought conditions, so the 200-week MA hurdle could prove a tough nut to crack.

A healthy pullback ahead of the key long-term MA could help the pair build steam for a strong break higher.

The rally isn't backed by a rising yield spread and is vulnerable to a corrective rally in Chinese Yuan. That said, the overall outlook remains bullish while the pair is trading above 111.40 (May 21 high).

A daily close below 111.40 would abort the bullish view and a daily close below the rising trendline (seen in the daily chart) would signal a bullish-to-bearish trend change.