USD/JPY drops to one-week low, further below 128.00 mark amid slump in equity markets

• A combination of factors dragged USD/JPY lower for the second successive day on Thursday.
• Recession fears continued weighing on investors’ sentiment and boosted the safe-haven JPY.
• Retreating US bond yields prompted some USD selling and further contributed to the decline.
• The Fed-BoJ policy divergence warrants some caution before placing aggressive bearish bets.

The USD/JPY pair weakened further below the 128.00 mark during the first half of the European session and dropped to a one-week low in the last hour.

The pair struggled to capitalize on its early positive move, instead met with a fresh supply in the vicinity of the 129.00 round figure and turned lower for the second successive day on Thursday. The prevalent risk-off environment boosted demand for the safe-haven Japanese yen, which, along with the emergence of fresh US dollar selling exerted downward pressure on the USD/JPY pair.

The markets now seem worried that a more aggressive move by major central banks to constrain inflation could hit global economic growth. Adding to this, extended COVID-19 lockdowns in China and the Russia-Ukraine war have been fueling recession fears. This, in turn, took its toll on the risk sentiment and forced investors to take refuge in traditional safe-haven assets, including the JPY.

The anti-risk flow triggered modest pullback in the US Treasury bond yields, which prompted some US dollar selling and further contributed to the offered tone surrounding the USD/JPY pair. With the latest leg down, spot prices have now dropped back closer to the monthly low, around mid-127.00s touched last week, though the Fed-BoJ monetary policy divergence should act as a tailwind.

The Fed is widely expected to stick to its monetary policy tightening path and hike interest rates by at least 50 bps at the next two policy meetings. The bets were reaffirmed by Fed Chair Jerome Powell's comments on Tuesday, saying that he will back interest rate increases until prices start falling back toward a healthy level. This should limit the downside for the US bond yields and the buck.

In contrast, the Bank of Japan has vowed to keep its existing ultra-loose policy settings and promised to conduct unlimited bond purchase operations to defend its “near-zero” target for 10-year yields. Hence, it will be prudent to wait for some follow-through selling below the 127.50 region before confirming a fresh bearish breakdown and positioning for any further depreciating move.

Market participants now look forward to the US economic docket, featuring the release of the Philly Fed Manufacturing Index, the usual Weekly Initial Jobless Claims and Existing Home Sales data. Apart from this, the US bond yields will influence the USD and provide some impetus to the USD/JPY pair. Traders will take cues from the broader market risk sentiment to grab short-term opportunities.

Technical levels to watch