Despite escalating conflict in the Middle East, USD/JPY has rallied as traders prioritise what higher oil prices mean for the Fed’s policy outlook over traditional haven flows. With yield differentials regaining influence, guidance from Powell and Ueda could prove decisive in the days ahead.
By :David Scutt, Market Analyst
USD/JPY Outlook Summary
The inability for the Japanese yen to sustain initial gains on Friday despite a significant increase in geopolitical tensions suggests traders are more concerned about the implications for the U.S. interest rate outlook from higher oil prices than capital preservation, likely explaining the sharp rebound in USD/JPY seen during the session. Correlation analysis backs this up, with its relationship with yield differentials between the U.S. and Japan firming last week. Should that persist, it suggests USD/JPY direction may be driven by rate decisions from the U.S. Federal Reserve and Bank of Japan (BOJ) in the coming days, rather than geopolitics. With neither bank expected to adjust policy settings, it suggests guidance on the interest rate outlook may be the key piece of information for traders to act upon next week.
Higher Yields Now Deemed USD Supportive
Source: TradingView
Interest rates matter again for USD/JPY, as shown by the moderately strong relationship with yield differentials between the United States and Japan over two, five, and 10-year tenors last week. While correlation coefficients of between 0.62–0.67 are not particularly strong—and significantly weaker than periods in the past—relative to other historic drivers like the performance of riskier assets and volatility measures, the relationship has still been far more meaningful recently.
Source: TradingView
Underlining that point, it’s notable that U.S.–Japan yield differentials widened sharply across the curve on Friday in response to the escalation in geopolitical tensions in the Middle East, coinciding with a similar reversal in USD/JPY during the session. Rather than Treasuries behaving as a haven, it suggests bond traders are more interested in what the conflict may mean for the U.S. interest rate outlook through higher energy prices.
Click the website link below to read our exclusive Guide to USD/JPY trading in Q2 2025
https://forex.com/en-us/market-outlooks-2025/q2-usd-jpy-outlook/
Fed, BOJ Top Event Risk
While the Middle East conflict has the potential to heavily influence USD/JPY should we see a major escalation or de-escalation in tensions, without fresh catalysts, the strengthening relationship with rate differentials means the Federal Reserve and BOJ policy meetings are two events that traders cannot afford to overlook next week.
Source: Bloomberg
As shown by pricing based on swaps markets, rates traders see almost no chance of either the Fed or BOJ moving policy rates in June, meaning that outside of a shock move, it will be commentary on the rates outlook that will drive USD/JPY movements. Looking at the individual meetings, the FOMC decision screens as being far more likely to spark an increase in volatility. Not only will traders receive the policy statement and press conference from Chairman Jerome Powell but also updated economic and interest rate projections from individual FOMC members.
Source: Federal Reserve
When last updated three months ago, the median member forecast looked for two rate cuts this year—a view similar to current market pricing, which looks for two with a small risk of a third. This will be the key piece of information to look out for, with any shift from previous guidance likely to spark a kneejerk reaction in USD/JPY.
With so much macro uncertainty, Fed officials may choose to play it safe and retain the same guidance as March. However, given the recent spate of inflation undershoots—despite the implementation of higher tariffs on imported goods—if the Fed is to deliver a surprise, it’s more likely to be dovish than hawkish.
It’s obvious labour market conditions are softening, so why continue to set policy to restrict economic activity? Yes, the risk of higher goods inflation is something that needs to be considered, but we’re only talking about a small proportion of the U.S. CPI basket. Services inflation, which is far more representative of domestic economic conditions, continues to ease, providing an offset to the risk of higher goods inflation.
If that dovish tilt materialises in the Fed’s updated forecasts, it may act to push USD/JPY lower.
In contrast to the Fed meeting, the BOJ decision may be easier for traders to navigate with only a policy statement and press conference from Governor Ueda to digest. The bank will point to the highly uncertain international environment as a reason to keep policy unchanged but will likely retain a conditional tightening bias pointing to an eventual resumption of rate hikes if activity and inflation evolve in line with its forecasts. Governor Ueda has often come across as more dovish relative to the broader BOJ board recently, meaning only a hawkish tilt carries the potential to shake things up for the yen. Such a risk appears highly unlikely.
U.S. Retail Sales, Japan Inflation Key Data Releases
Source: LSEG Workspace (U.S. EDT shown)
Looking beyond monetary policy, other risk events that carry the potential to deliver volatility include U.S. retail sales and Japanese inflation figures for May. Trade and geopolitical headlines will create constant headline risk, with any negative developments more likely to work in favour of the yen than dollar. A 20-year Treasury auction on June 16 is another to keep on the radar given the influence it may have on longer-dated yields.
Click the website link below to read our Guide to central banks and interest rates in Q2 2025
https://forex.com/en-us/market-outlooks-2025/q2-central-banks-outlook/
USD/JPY Downside Looks Tough Going
Source: TradingView
Downside for USD/JPY looks like tough going next week in the absence of a major risk-off episode, with the pair continuing to attract bids beneath uptrend support dating back to the lows hit in April. That’s the first downside level of note, with a broader support zone between 142.42 down to 141.65 located just below. Having been given every excuse to revisit the April lows in recent weeks, the inability to do so provides hints as to where near-term directional risks may lie.
144.00 remains a key level to watch, with the price doing plenty of work either side of it over the past month. Offers have emerged above the 50-day moving average and 145 recently, so keep that in mind if you’re playing USD/JPY from the long side. 146 looms as a tougher test for bulls. Momentum indicators are generating neutral signals, putting more emphasis on price action rather than acting with a specific bullish or bearish bias.
– Written by David Scutt
Follow David on Twitter @scutty
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