Why is the Japanese Yen trimming gains as bond yields decline despite firmer inflation?

• As the Japanese Yen surrenders its earlier gains, USD/JPY rebounds from a five-week low.
• Despite firmer domestic inflation, the Yen comes under pressure from declining Japanese bond yields.
• With the Fed and BoJ expected to keep rates unchanged next week, markets await signals on December rate hikes.

A retreat in the Japanese Yen helps USD/JPY erase its earlier losses on Friday, following a fall to a five-week low of 156.08 in the Asian session. Continued declines in Japanese government bond yields weigh on the Yen. US Treasury yields, by contrast, steady after the previous day’s steep fall, allowing the US Dollar to retain its footing near recent lows.

Trading around 15.77 at the time of writing, the pair is broadly unchanged for the day. The US Dollar Index (DXY), which measures the Greenback against a basket of six major currencies, stands near 101.70, having reached a three-week low of 101.45 on Thursday.

Concerns over AI-related investments had prompted investors to seek safety in the Japanese Yen and government bonds on Thursday, lifting the currency across the board. After dropping 16.6 basis points (bps) to 4.95%, the benchmark 10-year US Treasury yield recovered towards 4.99% on Friday. Japan’s 10-year government bond yield, meanwhile, declined by more than 10 bps to roughly 2.76%, marking its lowest level since early August.

Firmer inflation readings at home have also failed to support the Yen. September’s National Consumer Price Index (CPI) in Japan increased 2.1% YoY, compared with 1.9% in August. Excluding fresh food, inflation climbed from 1.8% to 2.1%, in line with expectations and above the Bank of Japan’s (BoJ) 2% target. The measure excluding food and energy picked up from 2.0% to 2.4%.

With inflation still below the BoJ’s projection, Brown Brothers Harriman strategists caution that the central bank is "unlikely to crank up the pace of tightening with headline and core CPI inflation tracking below its 2026 projection of 2.5%." Highlighting a gradual policy path, they observe that the swaps curve currently "prices in just 2% odds of a 25bps BoJ rate hike to 1.50% on October 30, and 80% probability of a hike on December 18,"

Against this backdrop, BBH’s expectation is for "USD/JPY likely to trade within a 155.00-160.00 range in the near term," although it cautions that "a deeper rout in the AI trade can fuel more safe-haven demand for JPY and drive the cross below 155.00."

Friday’s US data put the preliminary S&P Global Composite PMI at 57.6 for October, down from September’s 58.4. Manufacturing PMI edged up from 55.9 to 56.0, exceeding the 55.6 forecast. Services PMI, however, slipped from 58.8 to 57.9, in line with expectations.

An upward revision took the University of Michigan’s final Consumer Sentiment Index from 46.3 to 48.0. Its one-year and five-year inflation expectations remained unchanged at 4.7% and 3.5%, respectively.

Following September’s 25 bps increase, the Fed is also expected to maintain interest rates at next week’s meeting. With higher energy prices stemming from Middle East tensions keeping inflation risks skewed upwards, traders will look for guidance on the future rate path. An 80% probability of a December hike is currently priced into markets.