The USD/JPY pair drops to a fresh year-to-date (YTD) trough during the first half of the European session on Friday, albeit manages to recover a few pips in the last hour. Spot prices currently trade around the 140.75 region, still down over 0.75% for the day, and seem vulnerable to slide further.

The divergent Federal Reserve (Fed)-Bank of Japan (BoJ) policy expectations led to the recent narrowing of the US-Japan rate differential and continued to prompt the unwinding of the Japanese Yen (JPY) carry trades. In fact, the markets started pricing in the possibility of a larger interest rate cut by the US central bank following the release of the softer-than-expected US Producer Price Index (PPI), which indicated that inflation is subsiding. 

Dovish Fed expectations, meanwhile, drag the yield on the benchmark 10-year US government bond to its lowest level since May 2023. Meanwhile, Japan’s 10-year government bond yield also fell to a four-week low, though hawkish signals from BoJ policymakers should limit the fall. BoJ board member Junko Nakagawa said this week that the central bank will raise interest rates further if the economy and inflation move in line with its forecasts. 

Adding to this, BoJ board member Naoki Tamura said on Thursday that the central bank must push up short-term rates to at least around 1% through fiscal 2026 to stably achieve the 2% inflation target. This, in turn, reaffirms bets that the Japanese central bank will announce another interest rate hike by the end of this year, which might continue to drive flows toward the JPY and support prospects for a further depreciating move for the USD/JPY pair. 

That said, the upbeat market mood might keep a lid on any further JPY gains as traders look forward to next week's key central bank event risks before placing fresh directional bets. The Fed is scheduled to announce its decision at the end of a two-day policy meeting on Wednesday. This will be followed by the BoJ policy update on Friday, which will play a key role in influencing the USD/JPY pair in the near term. Nevertheless, spot prices remain on track to register losses for the second straight week – also marking the third in the previous four.

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