Exploring the Key Drivers of the USD/JPY Currency Pair

Many people find trading the Japanese yen against the US dollar (USD/JPY) to be quite demanding. Nevertheless, if the Japanese yen (JPY) is understood in terms of US Treasury bonds, it may be easier to comprehend the forces that drive the pair.

In addition to bonds, interest rates in Japan and the US are also major driving forces behind this currency pair. This means that the pair is a risk measure that indicates whether to purchase or sell the USD/JPY in respect of interest rates. The movement of this pair is governed by the movement of interest rates.

USD/JPY currency pair definition

The currency exchange rate between the US dollar and the Japanese yen is represented by the abbreviation USD/JPY. The pair depicts how much yen is necessary to purchase a US dollar. The JPY serves as the quotation currency, and the USD serves as the base currency. The exchange rate of the pair is one of the most liquid, as well as one of the most traded worldwide. This is because the yen, like the US dollar, is a reserve currency.

Those that trade currencies are typically aware that the optimal time to trade this currency pair is between 8 a.m. and 11 a.m. ET. Since there is more movement and turbulence in the market throughout this three-hour time frame, there is a greater chance of identifying the biggest price moves. Even if markets in Tokyo are closed, markets in London and New York are open.

Understanding the USD/JPY currency pair

The USD/JPY pair is denominated in the Japanese yen per US dollar. For example, if the pair is trading at 150, that signifies that one US dollar is worth 150 yen. Because of Japan’s position as the world’s third-largest economy and a significant exporter, USD/JPY is one of the most liquid and widely traded currency pairings in the world.

The USD/JPY rate is influenced by variables that impact the value of the US dollar and the Japanese yen with respect to one another and to other currencies. The difference in interest rates between the Federal Reserve and the Bank of Japan (BoJ) has a significant impact on the USD/JPY exchange rate. Higher interest rates make a currency more appealing by allowing owners of assets denominated in that currency to receive a higher yield.

For example, if the federal funds rate rises from near zero to 2% while the Bank of Japan’s policy rate remains around zero, the dollar would tend to strengthen versus the yen because investors will be able to earn a much greater yield in dollar-denominated money markets.

In reality, when the Bank of Japan failed to follow other central banks in hiking interest rates, the yen dropped to a 24-year low versus the dollar in mid-2022. Japan’s central bank and government have continued to see long-term deflation as a greater danger than short-term inflation caused by increasing oil costs.

USD/JPY: A safe haven?

Because of Japan’s low domestic interest rates under deflation, the yen has become a safe haven currency, with its value rising during moments of market upheaval. During periods of market stress, the flow of Japanese investment capital into higher-yielding foreign currencies such as the US dollar has tended to reverse, causing the yen to appreciate versus the dollar.

During the Great Recession, this was evident when the USD/JPY exchange rate dropped from 120 in 2007 to around 90 by 2009. In contrast, as risk tolerance in financial markets rises, the yen tends to fall. As the global economy recovered in the years following the Great Recession, the yen gradually depreciated against the US dollar. The deterioration worsened in 2013 when the Bank of Japan raised interest rates.

Major bodies affecting the USD/JPY

1. Ministry of Finance

The Ministry of Finance (MoF) is Japan’s single most important political and monetary organisation. Its effect on currency policy is greater than that of the US, UK, or German finance ministries. MoF officials frequently make economic pronouncements that have a significant influence on the yen. These remarks involve verbal intervention aimed at preventing unfavourable yen appreciation/depreciation.

2. Bank of Japan

Japan implemented new regulations in 1998 that granted the central bank (BoJ) operational autonomy from the Ministry of Finance. While the BoJ has now complete control over monetary policy, the MoF is still in charge of foreign exchange policy.

The Bank of Japan (BoJ), which is infamous for many market interventions, is the biggest influencer on the USD-JPY. The Bank of Japan publishes interest rates monthly, along with rate announcements that provide traders and investors an insight into future policy direction.

3. Interest Rates

The major short-term interbank rate is the Overnight Call Rate. The call rate is determined by the Bank of Japan’s open market operations, which are aimed to manage liquidity. The call rate is used by the Bank of Japan to convey monetary policy changes that affect the currency.

Japan’s Statistics Bureau also publishes key statistics on a regular basis, which may have a substantial influence on the USD-JPY exchange. Because Japan’s economy is based on exports, data such as the Trade Balance, GDP, and Current Account almost always cause significant volatility in the USD/JPY exchange rate.

The US Federal Reserve publishes interest rates eight times per year. The Japan Meteorological Agency is an important organisation that might affect USD-JPY pricing since Japan is prone to earthquakes. The USD/JPY market may be impacted by severe earthquake signals sent out by the Earthquake Early Warning (EEW) system, which can put pressure on the Japanese yen.

4. Ministry of Economy, Trade and Industry

A government entity aiming at promoting Japanese industry’s interests and safeguarding Japanese firms’ international trade competitiveness. METI’s influence and visibility are not what they were in the 1980s and early 1990s when US-Japan trade concerns were the “hottest” subjects in the world of foreign exchange.

5. Economic Data

Japan’s most important economic data items include GDP, the Tankan survey (quarterly business sentiment and expectations survey), foreign trade, unemployment, industrial production, and the money supply.

6. Nikkei

Japan’s most important stock index. A moderate fall in the yen often increases stocks of export-oriented firms, which tends to lift the entire stock index. The Nikkei-yen connection can occasionally be inverted, with a strong open market in the Nikkei appearing to raise the yen as investors’ money flow into yen-denominated companies.

7. Cross-rate effect

The USD/JPY exchange rate is occasionally influenced by fluctuations in cross-currency rates such as EUR/JPY and GBP/JPY. A rising USD/JPY (increasing dollar and dropping yen) might be the outcome of an appreciating GBP/JPY rather than direct dollar strength. The increase in the cross rate might be attributed to differing sentiments between Japan and the United Kingdom.

Final thoughts

The economic rules of supply and demand, which are also strongly related to bond pricing in their respective nations, will eventually play a significant role in pricing when examining the link between the USD/JPY currency pair. Carry trades, also known as USD/JPY shorts, are one method investors may express their opinions on the pair. The market often perceives carry trades as bad for Japan’s economy since they devalue the country’s currency.

However, if Japan returned its yen to its home country, this would be positive for USD/JPY and a buy indicator because it would weaken its currency and boost its economy.

Disclaimer:

This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.