Business sentiment in Japan is likely to falter in Q1 as a stronger yen hurts exporters and a global credit crunch increases borrowing costs and damages prospects for growth worldwide. Last quarter, the Business Sentiment Index for not only manufacturers, but all industries, proved to be optimistic as companies were confident that the economy would be able to weather the storm of a possible recession in the US. This time around, however, the situation is quite different, and businesses are rightfully worried as the OECD recently forecasted that Japanese economic growth will slow to a tepid 0.3 percent pace in Q1, down from 0.9 percent in Q4.

What Are the Markets Facing?

Business sentiment in Japan is likely to falter in Q1 as a stronger yen hurts exporters and a global credit crunch increases borrowing costs and damages prospects for growth worldwide. Last quarter, the Business Sentiment Index for not only manufacturers, but all industries, proved to be optimistic as companies were confident that the economy would be able to weather the storm of a possible recession in the US. This time around, however, the situation is quite different, and businesses are rightfully worried as the OECD recently forecasted that Japanese economic growth will slow to a tepid 0.3 percent pace in Q1, down from 0.9 percent in Q4. The performance of businesses in Japan is of great concern to the BOJ, and the bank’s interim governor, Masaaki Shirakawa, said on Friday that nation’s economy "is facing many uncertain factors. We need to closely examine both upside and downside risks." However, with interest rates already at an ultra-low 0.50 percent, the BOJ doesn’t have much room for maneuver when it comes to adjusting monetary policy. Nevertheless, Shirakawa also said that the Bank should aim to achieve sustainable growth and stable prices by taking “necessary policy actions flexibly,” which raises the potential for rate cuts in the future. Indeed, the past four consecutive policy meetings resulted in a unanimous vote to leave rates steady, as even the sole hawk on the monetary policy board, Atsushi Mizuno, backed off in December in light of the tumultuous credit market conditions and its threat to the economies of the US, UK, and Europe. As a result, a disappointing BSI release may only lead speculation of an impending rate cut to be exacerbated amongst traders.

Bonds – 10-Year Japanese Government Bonds

Japanese government bonds have surged quite a bit amidst major flight-to-safety in the global markets, though gains have paused at resistance near 142.00. Japanese economic data early next week could help give the contract a boost, as souring business confidence raises the risk the BOJ may actually cut in the near-term. On the other hand, additional gains in the Nikkei could weigh JGBs towards 140.

FX – USD/JPY

The Japanese yen has gradually weakened against the greenback in recent days, and the consolidation of USD/JPY within an ascending triangle creates the potential for a breakout to the upside. Furthermore, according to Technical Strategist Jamie Saettele’s Elliot Wave analysis, USDJPY is likely to rally towards 102 (Join other traders in discussing Elliott Wave Theory on the DailyFX Forum). However, USD/JPY has had difficulty breaking above 100 and low trading volumes ahead of the holidays have not helped the case, but Japanese economic data due to be released early next week could spark a break higher in USD/JPY, with a solid rally targeting 102 or 103.50 The Business Sentiment Index is anticipated to reflect souring confidence in the first quarter, which may raise the risks that the Bank of Japan will cut rates. With interest rates already at an ultra-low 0.50 percent, the news will do little to support a bid tone for the yen from an interest-rate-differential perspective. On the other hand, if risk aversion starts to dominate price action once again, USD/JPY could retreat to the 96 level once again.

Equities – Nikkei 225 Index

The Nikkei 225 Index has bounced from trendline support at the 11,700 level, as gains in the financial sector helped offset declines in miners as commodities continue to pull back. If news flow remains thin next week, Japanese equities could benefit and push the Nikkei above resistance at 12,600, but the release of the Business Sentiment Index could counter any gains. Indeed, BSI is likely to fall in line - boding ill for the upcoming Tankan reading – which may raise fears that business will be less profitable.

Terri Belkas is a Currency Strategist at FXCM.