USD/JPY Extends its Slump, in the Aftermath of a Reserved Fed & USD GDP Contraction

US GDP Contraction

The US economy contracted for second straight quarter, as yesterday's preliminary data showed that annualized GDP slumped by 0.9% in the second quarter of the year, after an 1.6% decline in Q1.

Although there is no universally accepted definition, it is generally believed that two straight quarters of economic contraction, constitute a recession. However, one has to take into account that this is just the first reading and the figures tend to be revised significantly, until we get to the final print.

Fed-Chair Powell alluded to that fact, noting that "you tend to take first GDP report I think with a grain of salt", during his press conference on Wednesday. He also dismissed recession fears and pointed to many areas of the economy that do well, such as the labor market, clearly stating that "I do not think the US is currently in a recession". ^[1]

On the other hand, there are other indicators that point to a recession, such as the inversion of the yield curve, since the 10-year yields are below the 2-years ones for a while now.

Reserved Fed

The US central bank delivered another aggressive 0.75 rate hike earlier in the week, having raised them by a cumulative 225 basis points since March, in what can only be described as a very aggressive and front loaded tightening cycle.

This is done in order to bring down decades-high inflation, which so far has not happened and as long as things don't change, it will be hard for the Fed to stray away of this path.

Despite the Fed's defiance around the prospects of a recession, Mr Powell tried on Wednesday to prepare markets for less aggressive hikes ahead and yesterday's GDP print is seen as something that could lead the central bank to take its foot of the pedal.

Fed-BoJ Differential

Even if the Fed's hawkishness has peaked or nears a peak, the divergence with the Bank of Japan remains stark, since the latter continues to implement ultra-easy monetary policies, including tapping into the bond market to control the yield curve.

The BoJ has not wavered from this stance, even as CPI inflation (excluding fresh food) has been above the 2% target for three consecutive month now.

Today's Summary of Opinions of this month's latest policy meeting, acknowledged the recent rise in prices, but also that "achieving the price stability target in a stable manner is difficult". Furthermore, it mentioned that "it is appropriate for the Bank to continue with the current monetary easing". ^[2]

USD/JPY Analysis

This stark policy differential has sent the pair to an impressive rally that culminated to nearly 24-year highs earlier in the month. However, as Fed tightening expectation have eased recently, there has been a correction since then and the pair heads towards its worst month since 2019.

USD/JPY extents its slump with losses of around 1% today and breaches the 133.00 area and the 23.6% Fibonacci from the 2022 Low/High advance, something for which we had warned in our analysis at the start of the week. This creates risk for a test of the 38.2% Fibonacci (129.48), but we are coutious, whereas the DMA200 is distant (mid-124.00s).

Despite the two-weeks plunge and the easing of expectations around the Fed, the divergence with the BoJ is hard to justify much more USD/JPY weakness. Furthermore, the drop is overextended, since the Relative Strength Index moves to the most oversold levels of the year.

Current levels and the Ichimoku Cloud have the potential to contain the slump, but the greenback will need a catalyst to propel it back above the EMA200 (135.70). This would pause the near-term downward bias and could eventually lead to higher highs towards 142.49, but it is early to talk about that.

In any case, the next leg of the move will probably be determined by today PCE Inflation from the US, so caution is needed.