Central Banks and Energy Prices Set to Determine USD/JPY Direction

The upcoming Fed and BOJ decisions are expected to dominate the headlines this week. However, market analysts believe that unless there's a shock rate call from either central bank, the decisions themselves may not generate significant volatility. Instead, it will come down to signalling, with the updated Fed dot plot and economic projections being key indicators of the policy outlook.

The BOJ is expected to deliver a 25 basis point hike, which is fully priced in the market. The focus will be on whether the BOJ can sustain the hawkish shift in expectations that's taken place over the past month. OIS pricing has moved materially higher across the curve, with almost a second hike by year-end now priced and more than three hikes expected by the middle of next year.

Energy prices are also expected to play a crucial role in determining how USD/JPY performs this week. The correlation matrix shows a strong relationship between energy prices and US Treasury yields, particularly further out the curve. Over the past five sessions, WTI's correlation with 10 and 30-year yields stands at +0.78 and +0.96 respectively.

Kevin Warsh faces a credibility test this week as he prepares to deliver his first interest rate decision as Fed Chair. Market pricing for a 25 basis point hike has lifted to around 90%. If the Fed doesn't hike and ignores what markets are signalling about where the appropriate rate should sit, it risks doing serious damage to its credibility and triggering a disorderly reaction.