USD/JPY Volatility Peaks Ahead of Fed and BOJ Rate Decisions

The Japanese yen's recent surge against the US dollar is an unusual phenomenon that has left many analysts scratching their heads. Historically, when US nominal and real yields rise, the yen would weaken, but in early September, it strengthened by 3.7% despite a sharp increase in US Treasury yields.

One reason for this unexpected move is the large-scale short covering among speculators, which was triggered by Japan's Ministry of Finance record yen intervention in August and US Treasury Secretary Scott Bessent's forceful rhetoric warning traders to take him on in shorting the yen.

Another factor contributing to the yen's strength is the BOJ's hawkish shift in pricing, which drove a significant sell-off at the front end of the JGB curve and pushed yields to fresh multi-decade highs. This repricing has helped drag yields higher further out the curve, narrowing part of the yield disadvantage that has traditionally worked against the currency.

However, not all bear steepening moves are created equal. When driven by increased term premium around rising fiscal concern, it can have a detrimental impact on the underlying currency, and this may be the case with the yen. The front end of the JGB curve sold off aggressively earlier this month due to concerns about Japan's fiscal position, but has since partially reversed.

The upcoming Fed and BOJ decisions will likely dictate directional risk for the USD/JPY pair. With both central banks expected to raise rates by 25 basis points, the guidance around these decisions may matter more than the actual rate hikes themselves. The Fed's updated dot plot, voting pattern, and Kevin Warsh's press conference will be closely watched, particularly whether policymakers can live up to the hawkishness priced into the US curve.