23.05.202319:39 Forex Analysis & Reviews: USD/JPY rally due to improved global risk appetite

Strong economy equals a strong currency. Does this principle always work? Looking at Japan's rapid GDP growth in the first quarter following the technical recession in the second half of 2022, the highest core inflation since 1981, and 33-year peaks in stock indices, one begins to wonder about the decline of the yen. The USD/JPY pair soared to semi-annual highs amid the Bank of Japan's reluctance to normalize monetary policy and the rally in U.S. Treasury bond yields.

The purchasing managers' indices indicate that the economy of the Land of the Rising Sun continues its upward trajectory. Business activity in the services sector jumped to a record 56.3 in May, thanks to the return of foreign tourists after the pandemic. The manufacturing PMI rose above the 50 mark for the first time since October 2022, indicating economic expansion.

Dynamics of business activity in Japan

Positive dynamics in GDP, business activity, and high inflation levels reflecting the strength of domestic demand are combined with improvements in external trade. Import volumes, influenced by falling energy prices, decreased for the first time since the beginning of 2021. This had a favorable impact on the trade balance and could serve as an argument for selling USD/JPY. Unfortunately, the yen found itself in an extremely unfavorable environment, and the Bank of Japan has no intention of moving away from ultra-loose monetary policy.

When global risk appetite surges and U.S. Treasury bond yields rise, the bears on USD/JPY feel out of their comfort zone. Especially since the Nikkei 225 soared to the vicinity of a 33-year peak. The stock index has a strong inverse correlation with the yen, as Japanese companies are considered export-oriented. Weakening the national currency contributes to the improvement of their financial results. Moreover, in dollar terms, stock prices have not risen as much, which keeps foreigners from buying them.

Dynamics of the Japanese stock market

Divergence in monetary policy plays in favor of the bulls on USD/JPY. The head of the Bank of Japan, Kazuo Ueda, believes that the risk of error is too great if normalization happens prematurely. In contrast, the presidents of the St. Louis Fed and the Minneapolis Fed, James Bullard and Neel Kashkari, insist on further raising the federal funds rate. The latter does not rule out its increase above 6%.

In such conditions, the rally in U.S. Treasury bond yields and the widening spread with Japanese counterparts seem logical. This leads to an increase in USD/JPY quotes to levels not seen since November 2022. However, in my opinion, the market is overstretching. Jerome Powell and some of his colleagues are talking about a pause in the process of monetary tightening in June. This could weaken the position of the U.S. dollar.

Technically, the inability of USD/JPY to hold above the pivot level at 138.4 would be a sign of weakness for the bulls and a reason to take profits on positions formed from 135.4 longs. It also makes sense to consider the possibility of short-term selling of the pair.