US 10-year bond versus Japan interest Rate Differential is Driving the Movements of USD/JPY

The balance of the summer will be a prelude to two big meetings that will occur simultaneously on September 20,21.  Both the Federal Reserve and the Bank of Japan will meet to decide on monetary policy.  It is clear that the underlying goals of these two major policy institutions are divergent at the current respective points in their economic cycles.  While the Fed is attempting to find windows where they can normalize rates, the BoJ is firmly entrenched in near zero interest rate policy while enhancing their asset purchase program.   The divergence in policy is likely to be the driver of the USD/JPY over the balance of 2016.

At its last meeting in July, the Bank of Japan left rates unchanged while altering its asset purchase program. The BoJ appear to have provided the backdrop for additional policy moves at the September 20th-21st meeting.  These comments left investors with the feeling that the BoJ was trying to tell the markets that monetary policy might not have further beneficial effects.

On the heels of keeping interest rates unchanged Japan announced a fiscal stimulus package of 13.5 trillion-yen in an effort to increase growth. The package includes payments to low-income earners as well as infrastructure spending in an effort to enhance the monetary stimulus provided by the Bank of Japan.

Japan 10-year tumbled shooting yields higher with the JGB (Japanese Government Bond) yield up from -0.29% in the last week of July to nearly zero in early August. All else being equal, this seems to suggest markets are giving the initially disappointing of the recent monetary and fiscal stimulus over the past week fresh credibility.

The decline in the USD/JPY appears to be a function of the recent movement in rates.   The rapid movement of the Japanese 10-year yields has been easily offset by the recent decline in U.S. rates. A softer than expected release of U.S. Q2 GDP caught the currency market by surprise and drove the currency pair toward support levels near the lows of 2016.

The chart of the 10-year yield differential between US 10 year treasury note and Japan 10 government bond and the currency pair USD/JPY shows that both instruments are heading toward support levels. The yield differential compares the yield on the U.S. Treasury to the Japanese government bond. Since yields make up the forward curve of the currency pair, it is a driving force behind the currency pairs movement.

As you can see, the correlation between the currency pair and the yield differential has been highly correlated since June.  The 93% correlation means that the two instruments are moving in tandem currently and that 93% of the movement of the currency pair can be described by the movement of the interest rate differential.

With both central banks poised to make choices about the future direction of monetary policy at the end of the summer, each new piece of monetary policy will provide the backdrop for changes in the currency pair. Strong data from the U.S. especially jobs and inflation data, will provide the stimulus needed for a stronger greenback.