Japanese Yen strengthens against US Dollar as inflation backs BoJ rate hike bets

USD/JPY trades around 158.85 on Friday at the time of writing, edging lower after rebounding from the 158.00 level on Thursday. The pair remains under pressure as the Japanese Yen (JPY) benefits from fresh inflation data supporting further monetary tightening in Japan, while the US Dollar (USD) remains close to its lowest levels since May.

In Japan, the core Consumer Price Index (CPI), which excludes fresh food, rose 1.8% YoY in July, following a 1.6% increase in June. This marks its fastest pace since January. The index excluding both fresh food and energy also accelerates to 1.9%, from 1.7% previously.

These figures reinforce expectations that the Bank of Japan (BoJ) could continue normalizing its monetary policy. The prospect of higher Japanese interest rates therefore provides support to the Japanese Yen, although the still-wide interest rate differential between the United States (US) and Japan could limit the Japanese currency’s appreciation.

On the US side, the US Dollar Index (DXY), which measures the Greenback’s performance against a basket of six major currencies, remains close to its lowest level since May 14. Investors are scaling back expectations of immediate monetary tightening by the Federal Reserve (Fed), although inflation risks continue to keep the possibility of another rate hike later this year alive.

The latest activity data nevertheless provide an argument for US policymakers favoring a restrictive monetary stance. The preliminary US S&P Global Composite Purchasing Managers Index (PMI) accelerated to 56 in August from 54.5 in July, signaling a faster expansion in private-sector activity.

The improvement is mainly driven by services. The S&P Global Services PMI rose to 56.8 in August from 54.6 previously, while the Manufacturing PMI slowed to 53.2 from 53.9 in July. Both indicators nevertheless remain above the 50 threshold separating expansion from contraction.

The resilience of the US economy could limit downside pressure on the US Dollar by reducing the need for monetary easing. For USD/JPY, the outlook therefore remains caught between expectations of a more restrictive BoJ, which support the Japanese Yen, and solid US economic activity that could sustain the higher-for-longer interest rate scenario in the United States.

Japan data bolsters BoJ tightening bets as JPY mood turns cautiously firmer

Strategists at Scotiabank highlight that Japan’s latest data run is reinforcing expectations for Bank of Japan tightening. They note that “Japan’s July CPI rose to 1.9% in the year, in line with expectations, extending the steady pick up in prices seen since February,” while “preliminary August PMI data reports were all stronger than expected as well, indicating firm momentum in services and manufacturing.”

According to Scotiabank, this combination of firmer inflation and activity “added marginally to conviction that the BoJ will tighten next month, with 20bps or hikes reflected in swaps.” They add that the “price data helped lift the JPY to a 0.4% rise against the soft USD on the day,” underscoring a modest but notable shift in currency sentiment.

From a market perspective, Scotiabank characterizes the technical backdrop as “neutral/bearish—A net loss for the USD on the week may herald some relief for the JPY. USD dips drew firm support last week but that conviction has not been evident this week.” In their view, “the near-term mood on the JPY may be shifting, if only slightly,” with “USD losses below 158.25” seen as potentially signaling “a bit more weakness ahead.”