USD/JPY Outlook: JGB bear steepening points to deeper trouble for the yen

• JGB bear steepening signals rising fiscal and inflation concerns
• Energy shock risks worsening Japan’s current account outlook
• BOJ FX intervention risks intensifying stress in long-dated JGBs
• Markets now price 14bp of Fed tightening this year

Bond vigilantes return to Japan?

Japan’s bond market is sending an increasingly uncomfortable message about the risks posed by prolonged disruption to global energy markets, with soaring long-dated yields and renewed yen weakness suggesting markets are becoming less convinced policymakers can contain the fallout without eventually sacrificing either the currency or the bond market.

That tension is on full display again Monday following reports the government may compile another supplementary budget to cushion the economic hit from the Middle East conflict, potentially requiring fresh debt issuance at a time investors are already demanding sharply higher compensation to hold longer-dated government bonds.

Source: TradingView

The 10-year JGB yield climbed to the highest level since 1996, while 20 and 30-year yields continued to push aggressively higher in another bear steepening move. While trading conditions further out the curve can often become thin and disjointed, exaggerating the size of individual moves even in Japan, the broader signal from investors about mounting inflation, economic and fiscal concerns is becoming increasingly difficult to ignore.

Importantly, while US front-end yields remain the primary driver for USD/JPY, especially with markets now pricing around 14 basis points of additional Fed tightening this year, Japan’s domestic backdrop is becoming an increasingly important secondary story when it comes to understanding why authorities appear increasingly constrained in their ability to repel further yen weakness.

Source: TradingView

For clarity purposes, the move in JGBs does not reflect markets pricing in aggressive BOJ tightening. If that were the case, the curve would likely bear or twist flatten as short-dated yields increase more than those for longer-dated bonds. Instead, swaps traders appear more concerned by a combination of the BOJ being behind the curve coupled with escalating fiscal and economic risks.

Source: Bloomberg

Japan’s energy vulnerability exposed

Japan is especially vulnerable in this environment given its near-total reliance on imported energy. Persistently high oil and gas prices threaten not only to lift inflation further but also weaken Japan’s current account position as more money flows overseas to pay for energy imports.

In simple terms, if Japan needs to sell more yen to buy foreign currencies for energy purchases while export revenues fail to keep pace, it can create another source of downward pressure on the currency at precisely the wrong time.

Defend the yen or cap yields?

The market reaction following suspected intervention activity earlier this month may also provide an important warning for policymakers. Once authorities moved to slow USD/JPY upside, pressure immediately migrated into the back-end of the JGB curve with long-dated yields surging higher. Rather than disappearing, the stress simply found another outlet.

That leaves Japanese policymakers facing an increasingly difficult balancing act. Allow yields to rise and concerns around debt sustainability intensify. But if the BOJ attempts to suppress volatility in longer-dated bonds through stepped-up market operations involving heavier bond buying, including unscheduled or emergency operations should volatility spike further, the pressure release valve may instead come through a much weaker yen.

USD/JPY marches towards 160

If large-scale JGB purchases were to be announced by the BOJ, it could see USD/JPY rip higher, potentially putting it on a collision course with the YTD high of 160.73 and, if broken, the multi-decade swing high of 161.95 set in 2024.

Source: TradingView

Right now, the pair is testing minor resistance at 159.00, continuing to push higher in an established uptrend from the lows set earlier this month during suspected intervention activity from the BOJ on behalf of the government. The price now trades above each of the key medium and longer-term moving averages, having breezed through the 50DMA earlier in the session. A break above 159.00 would increase the likelihood of a retest of the YTD highs.

Underneath current levels, downside support zones to watch include the 50DMA, the breakout zone at 157.92, followed by the 100DMA.

The momentum indicators are less useful in the current environment given the downside created earlier this month was driven by non-market forces. But even then, RSI (14) is trending higher above 50 while MACD has crossed the signal line from below and is motoring towards positive territory. Combined with recent price action, it continues to favour upside.

In the current market regime, BOJ intervention risks proving counterproductive, potentially doing little more than generating better levels for bulls to enter. As seen earlier this month, intervention not only failed to prevent a return towards prior levels but also risks exacerbating stress further out the JGB curve.