USD/JPY Forecast: Gravity Pull To Strengthen?

The Dollar-Yen pair is once again struggling to hold above 114.00 levels.

The Fed statement released yesterday showed the policymakers aren't second guessing a rate hike in December. However, the markets have priced-in a 25bps move, thus, the pair failed to take out the descending trend line hurdle.

The American dollar was offered across the board in Asia after news hit the wires that US tax bill will have only temporary cut in the corporate tax rate from 35 percent to 20 percent. It would revert back to the original 35 percent rate after a decade.

The USD/JPY dropped to 113.73 in Asia, only to trim part of its losses to trade around 113.95 levels. So is the 'temporary tax cut' news USD bearish? Following things are to be considered here:

The US economy is chugging along pretty well. Hence, Trumpflation (tax plan and fiscal stimulus), though desirable, is not a necessity.
Though temporary, a tax cut for 10 years is still in the pipeline.
There is low risk of a big equity market sell-off just because the tax cuts will be temporary. The markets remained bid in the first three quarters of this year, despite fading prospects of Trumpflation.
Furthermore, the Fed's hawkish forward guidance is not based on the assumption that tax plan/fiscal stimulus would be approved.
Thus, losses in the equity futures are likely to be short lived. No wonder, the USD/JPY pair has trimmed losses. Still, it is struggling to work its way above 114.00 levels. A number of factors could be playing spoil sport as discussed yesterday.

A few more points - flattening yield curve and confirmation of lagging bullish technical indicator - also indicate potential for a pullback in the USD/JPY pair.

Yield curve flattest since 2007

• A flatter yield curve (narrowing spread/difference between the US 10-yr yield and the 2-yr yield) is negative for the USD and vice versa.
• The December rate hike has been priced-in, thus the argument that the yield curve is flattening due to increased odds of short-term rate hike bets no longer holds ground.
• It could be an indication of any or all of the following - falling inflation expectations, concerns regarding economic growth or increased demand for long duration treasury yields (hedge demand, safe haven demand).
• Whatever the reason, a flatter yield curve could weigh over the USD/JPY pair. As of writing, the spread stands at 94.95 basis points; the lowest since 2007.

• Golden crossover, i.e, a bullish crossover between the 50-day MA and the 200-day MA, almost always works as a contrarian indicator in the short-run.
• The chart above does show a golden cross and exhaustion in the bull run around the resistance offered by the descending trend line drawn from the Aug. 2015 high and Dec. 2015 high.
• So, a pullback to 113.00 is quite likely in the short-run. The sell-off is seen gathering pace once the monthly low of 113.60 is breached.

President Trump is likely to announce the new Fed chair later today. Kathy Lien from BK Asset Management writes, "sources are also saying that Jerome Powell will be President Trump's pick for Fed Chair.  As the market has fully discounted a Yellen departure, as long as Trump picks Powell or Taylor and not someone from left field, the dollar will rise as the uncertainty recedes. The announcement is expected on Thursday along with the Republicans' tax reform bill, which was delayed from today. Unless there are any unexpected surprises on either front, the dollar should rise on these announcements."

 

The argument holds ground, although the sustainability of gains in the USD/JPY depends on the reaction from the 10-year US-Jap yield spread.

Yield spread chart

A convincing break above 238 basis points (December 2016 high) would open up upside in the USD/JPY pair towards 116.00 levels.

View

• Short-term pull back to 113.00 and possibly to 112.00 levels looks likely.
• A sustained move higher is likely if and when the yield spread rises above the Dec 2016 high of 128 basis points.