USD/JPY up sharply to test 21DMA at 113.80, as hot US inflation piles pressure on Fed

• USD/JPY has rallied sharply from Asia session lows under 113.00 and is testing its 21DMA at 113.80.
• A spike in US yields post-inflation data is widening US/Japan rate differentials and pushing the pair higher.

USD/JPY continues to recover from its earlier weekly lows under the 113.00 level and is now – in wake of a much hotter than expected US Consumer Price Inflation report – testing its 21-day moving average at 113.80. This means the pair is now trading about 0.8% higher on the day, its best one-day performance in a month.

The move is primarily being driven by a sharp rally in (nominal) US bond yields as traders up their bets that the Fed will take a more aggressive line on hiking rates to combat inflation, and as investors flee assets whose value is eroded by inflation (such as nominal bonds). 2-year yields are up 9bps to 0.50% and 5-year yields are up more than 10bps on the day to above 1.17%. That compares to a rally of just over 1bps in the 30-year yield. US yield curve flattening traders are betting on a combination of higher inflation/a more hawkish Fed response in the medium term (i.e. over the next up to five years), but are not significantly upgrading their long-term growth or inflation expectations.

Either way, higher yields and expectations for a more forceful Fed response to inflation has given US/Japan rate differentials a sizeable boost. USD/JPY is highly sensitive to rate differentials and is thus rallying as a result. As pressure builds on the Fed to drop its current stance that the spike in inflation is transitory, and thus doesn’t warrant a policy response, traders should lookout for any signs that the bank might shift policy in a hawkish direction. Any hints of this would send short-end US yields even higher, put further upwards pressure on US/Japan rate differentials, and likely push USD/JPY back to annual highs.

If USD/JPY is able to break to the north of its 21DMA, this will open the door to a run at the 114.00 level and the recent highs just above it in the 114.20-114.40 region. Bullish technicians may be targetting an eventual move back to annual highs just above 114.60.