This week the Bank of Japan is widely expected to keep its key interest rate unchanged and we expect the Japanese yen to be particularly vulnerable against the U.S. dollar on interest rate differentials.

The Bank of Japan is widely expected to keep its key interest rate on hold at 0.5 percent. Last week, a government report showed that the Japanese economy shrank an annualized 2.4 percent in the second quarter and downside risks to growth are likely to take center stage when the BoJ holds its two day monetary policy meeting. Moreover, according to overnight index swaps, which measure interest rate expectations for the next twelve months, traders expect the Bank of Japan to keep rates unchanged in 2008/2009. On the other hand, the U.S. Federal Reserve could be pressured to increase rates faster than traders had previously expected since the U.S. dollar currently offers negative interest rates when adjusted by inflation. In fact, we expect the Fed to increase rates by almost 150 bps in the next 18 months in order to keep up with inflation.

My trading bias is to go long USD/JPY ahead of the Bank of Japan interest rate decision for 300 pips in profit potential with a stop in a daily close below 109. The U.S. dollar has been very strong over the past month and we expect this trend to continue going forward.

Antonio Sousa is a Currency Analyst for FXCM.