The Bank of Japan left its key interest rate unchanged at 0.5% but downgraded its view of the Japanese economy. The Japanese yen could be particularly vulnerable against the U.S. dollar on interest rate differentials.

As widely expected the Bank of Japan kept its key interest rate on hold at 0.5 percent. The Bank of Japan said that “economic growth has been sluggish against the backdrop of high energy and materials prices and weaker growth in exports”. In fact, like we said yesterday, a government report showed that the Japanese economy shrank an annualized 2.4 percent in the second quarter and downside risks to growth would be likely to take center stage during the BoJ monetary policy meeting. The BoJ also said that while growth will likely remain sluggish for the time being, it is expected to return gradually onto a moderate growth path as commodity prices. Regarding inflation, the Boj said that even though CPI inflation rate is the highest since the first half of 1990s due to increased prices of petroleum products and food, it is expected to moderate gradually. Looking ahead, 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. Our trading recommendation is to go long USD/JPY 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.