USD/JPY Faces Pressure as US PPI Data Shows Weakening Inflation

USD/JPY faced selling pressure as the US Producer Price Index (PPI) data showed lower-than-expected 'factory gate' inflation, causing the Greenback to weaken against the Japanese Yen. The pair lost over 60 pips during the New York session and traded around the 139.35 area. All eyes are now on the Federal Reserve's (Fed) decision and revised dot plots.

The US Bureau of Labor Statistics released the PPI report, revealing a 0.3% month-on-month (MoM) decrease in May, surpassing the anticipated 0.1% slide. The year-on-year (YoY) measure also fell to 1.1%, indicating subdued inflationary pressures. However, the core figure, which excludes volatile food and energy prices, rose 0.2% MoM, in line with expectations, and registered a 2.8% YoY increase.

The weak PPI data led to a decline in US bond yields across the curve, putting further downward pressure on the USD. The 10-year bond yield dropped to 3.79%, the 2-year yield stood at 4.62%, and the 5-year yield settled at 3.96%, marking a significant decrease. Concurrently, the S&P 500 index (SPX) surged to its highest level since April 2022, diverting demand away from the safe-haven Greenback and towards riskier assets like the JPY.

Investors are now eagerly awaiting the Fed's decision, with the market strongly pricing in a pause in interest rate hikes. They will closely scrutinize the updated macro forecast, revised dot plots, and Chair Powell's press conference for any clues regarding the future path of monetary policy. The consensus expectation is that the Fed will resume tightening in the next July meeting with a 25 basis point (bps) hike.

In terms of technical analysis, USD/JPY is currently in a neutral stance for the short term. Indicators on the daily chart have turned red, indicating potential bearish pressure. However, the pair's trajectory in the coming sessions will largely depend on the outcome of the Fed's decision and market expectations for future rate hikes.

After losing the 20-day Simple Moving Average (SMA) at the 139.45 level, key support levels for USD/JPY are positioned at the psychological mark of 139.00 and the 200-day SMA at 137.25. On the upside, a move above the 140.00 zone would signal a continuation of the bullish trend, with further resistances located at the 140.50 area and a multi-month high at 140.90.

Meanwhile, the Bank of Japan (BoJ) is also garnering attention as it prepares to announce its interest rate decision. BoJ Governor Kazuo Ueda is expected to maintain the interest rate policy unchanged, underscoring the need for further monetary stimulus to sustain inflation above 2%. The central bank's commitment to ultra-loose policy settings and its focus on generating domestic demand make the yen an attractive funding currency for carry trades.

The divergence in monetary policies between the US and Japan has solidified the yen's status as the most preferred funding currency for carry traders. With Japan's negative-rate policy, the yen stands out with a low implied yield compared to other major currencies. This has fueled demand for carry trades, where investors take advantage of the interest rate differentials by borrowing in low-yielding currencies like the yen and investing in higher-yielding assets.

The attractiveness of the yen carry trade can be observed through the rising proxy for yen carry trades, which measures lending in yen by foreign bank branches in Japan. Since the end of 2021, this proxy has climbed by 48%, reaching 12.9 trillion yen ($92.4 billion) by the end of April. The popularity of carry trades involving the yen has contributed to its weakening trend against the dollar.

However, there are risks associated with the yen carry trade. Market volatility can quickly erode the gains from such trades, and any unexpected shifts in the BOJ's policy stance could impact the stability of the trade. Despite these risks, the current environment appears favorable, as indicated by the low level of expected currency fluctuations.

The USD/JPY pair has been impacted by expectations of a temporary halt to interest rate hikes by the Fed. However, the broader uptrend that began in March 2023 remains intact, with support around the 138.50 region holding firm. While the recent highs of May 30 at 140.9 have not been challenged, the overall bias for USD/JPY remains on the upside.

Market sentiment towards the yen and the USD/JPY pair will be influenced by the outcome of the Fed's decision and any hints of future rate hikes. Additionally, the BOJ's policy announcement will shape market sentiment towards the yen and further influence the trajectory of the USD/JPY pair.

In conclusion, the USD/JPY pair is facing a combination of factors, including the monetary policy disparities between the US and Japan, market sentiment driven by risk appetite, and the potential for further easing of US inflation. These factors will continue to drive the pair's movements and make it a focal point for investors in the coming weeks.