JPY vulnerable to further EUR/JPY rally in 2022After ECB warns inflation risk is shifting higherLeaving JPY at risk from unchanged BoJ policy

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The Japanese Yen was one of the best performing major currencies through much of January but it’s more recently begun to lose ground and could now be vulnerable to further losses as a recovering Euro lifts the EUR/JPY exchange rate during the months ahead, according to some strategists.

Japan’s Yen benefited from tumbling stock markets, faltering risk appetite among investors and a softer U.S. Dollar during the opening month of the year but it fell against all of the major currencies in the G10 contingent during the week to Friday.

While the faster moving Swedish Krona did manage to outpace the European single currency this week, the Japanese Yen’s losses against the Euro were almost equally significant after the EUR/JPY exchange rate rose by around 3% to reach three-month highs of 132.0 by Friday.

“Many remaining EUR shorts may still be in a 'NIRP stupor' which they have yet to shake off, leading us to believe that the cleanse on these positions hasn't fully run its course,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

“BMO's Economics Team now looks for the first hike of the cycle to come in December. Eurozone bank share prices are also benefiting from the prospect of a less negative ECB deposit facility rate, and we are now near-term EUR-bullish,” Gallo and colleagues wrote in a note to clients on Friday.

Above: EUR/JPY shown at daily intervals alongside USD/JPY and EUR/USD.

While the U.S. Dollar also advanced against the Yen this week, its increase paled into insignificance when compared with the rally seen in European exchange rates and notably those of the Euro.

The Euro was lifted sharply on Thursday after European Central Bank (ECB) President Christine Lagarde said that uncertainty about the Eurozone inflation outlook has increased and that risks are tilted to the upside along the immediate path ahead.

This led to widespread speculation in financial markets that a possible end to the era of negative interest rates could be near in Europe and prompted significant extension of an earlier rally in the Euro-Dollar rate, which has also driven the EUR/JPY pair higher.

However, and although the Euro-Dollar rally was significant, the increase in EUR/JPY was larger and the BMO Capital Markets team sees the latter exchange as being likely to have the most upside potential out of the two going forward.

“If the Fed follows through with 5 rate hikes this year and a summer QT commencement, while the ECB commits in March to ending QE in 6-10M (implying a late-2022 rate hike), this extent of policy divergence should at least prevent sustained USD selling vs the EUR, though we are more inclined to think it would send EURUSD lower. So with that in mind, we would advocate that EUR bulls focus on buying EURJPY,” Gallo wrote to clients on Friday.

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The reason is that there’s a chance - if not high degree of likelihood - that the Federal Reserve will lift its interest rate much further and faster than the European Central Bank this year, which could see the Euro-Dollar rate coming under pressure again later in 2022.

But no such policy action is expected from the Bank of Japan this year or next, which is why BMO Capital Markets and others say that buying the EUR/JPY exchange rate would be better way for speculative traders to play the possibly impending shift in European Central Bank monetary policy.

“We continue to believe any tweaking of the BoJ’s monetary policy will have to wait until there is significant turnover in its Board, which will not occur until April 2023 and when there will be five Board members replaced,” says Valentin Marinov, global head of FX strategy at Credit Agricole CIB.

“So while JGB yields were higher this week, partly in anticipation of the BoJ potentially tweaking policy in 2022, we believe it is too early. So, the JPY will continue to underperform most of the rest of the G10,” Marinov and colleagues wrote in a Friday research briefing.

Above: EUR/JPY shown at weekly intervals alongside USD/JPY.