Japanese Yen pares gains as bond yields fall despite stronger inflation

• USD/JPY recovers from a five-week low as the Japanese Yen gives back earlier gains.
• Falling Japanese bond yields weigh on the Yen despite stronger domestic inflation.
• The Fed and BoJ are expected to hold rates steady next week, with attention on December hike signals.

USD/JPY reverses earlier losses on Friday after slipping to a five-week low of 156.08 during Asian trading hours. The Japanese Yen loses ground as Japanese government bond yields extend their slide, while US Treasury yields stabilise after the previous day’s sharp decline, helping the US Dollar hold its ground near recent lows.

At the time of writing, the pair trades around 15.77, little changed on the day. Meanwhile, the US Dollar Index (DXY), which tracks the Greenback's value against a basket of six major currencies, trades around 101.70 after touching a three-week low of 101.45 on Thursday.

The Japanese Yen strengthened across the board on Thursday as worries about AI-related investments sent investors seeking safety in the currency and government bonds. The benchmark 10-year US Treasury yield fell 16.6 basis points (bps) to 4.95% before recovering toward 4.99% on Friday. Meanwhile, Japan’s 10-year government bond yield fell by more than 10 bps to around 2.76%, its lowest level since early August.

The Yen also fails to capitalise on stronger domestic inflation data. Japan’s National Consumer Price Index (CPI) rose 2.1% YoY in September, up from 1.9% in August. The measure excluding fresh food increased to 2.1% from 1.8%, matching expectations and moving above the Bank of Japan’s (BoJ) 2% target. Inflation excluding food and energy accelerated to 2.4% from 2.0%.

Strategists at Brown Brothers Harriman caution that the BoJ is "unlikely to crank up the pace of tightening with headline and core CPI inflation tracking below its 2026 projection of 2.5%." They note 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," underscoring a measured policy trajectory.

In this context, BBH expects "USD/JPY likely to trade within a 155.00-160.00 range in the near term," while warning that "a deeper rout in the AI trade can fuel more safe-haven demand for JPY and drive the cross below 155.00."

On the US side, data released on Friday showed the preliminary S&P Global Composite PMI eased to 57.6 in October from 58.4 in September. The Manufacturing PMI rose to 56.0 from 55.9, beating expectations of 55.6, while the Services PMI fell to 57.9 from 58.8, matching forecasts.

Meanwhile, the University of Michigan’s final Consumer Sentiment Index was revised up to 48.0 from 46.3, while one-year and five-year inflation expectations held at 4.7% and 3.5%, respectively.

The Fed is also expected to leave interest rates unchanged at next week’s meeting after raising them by 25 bps in September. Traders will watch for clues on the interest rate path as higher energy prices linked to Middle East tensions keep inflation risks tilted to the upside. Markets currently price in an 80% chance of a December hike.