Fundamental Outlook for Japanese Yen: Bullish

- Risk appetite plunges sending the DailyFX Carry Trade Index to two year lows
- Concerns over slowing global growth and an imminent banking collapse keeps dollar advance at bay

The Japanese yen has been heavily bid in most corners of the currency market, and the volatility is only expected to increase going into next weekend. Looking at the liquid yen crosses, USD/JPY doesn’t offer a good reflection of the Japanese currency or its direct link to risk sentiment and the carry trade. In fact, this pair has been more or less range bound because the other dominant theme in the market (buying dollars) has masked what is easily a market-wide crisis.

Heading into this past Friday’s close, rumors that the US government was working on a plan to bail out struggling mortgage behemoths Freddie Mac and Fannie Mae, the details of which were expected to be released as early as Saturday, led traders with risk-sensitive trades still open to panic. At the time of this writing, this is still an unsubstantiated quote from a WSJ article; but the market has been expecting this for some time (that and the collapse of a major US bank). No doubt, immobilized traders will be scanning the headlines all weekend long for confirmation of this story. Looking back to March, the Fed used the weekend to arrange its bailout of Bear Stearns; so investors had enough time to fully absorb the implications of the deal – and the markets were generally soothed by this action (it marked the bottom for USD/JPY). However, this assist is far more complicated. Depending on the details of the no-doubt ‘creative’ plan the Fed would make, the government will have to take the responsibility for their combined $5 trillion in mortgages (few collections of banks could handle this load, and fewer would want to). This will be a considerable burden on the US government’s coffers and will in turn dim foreign investors’ view of the US government and economy. What’s more, a second bailout would be mere confirmation that conditions in the credit market have only worsened with time (not much of an argument when the banks have already tallied more than $500 billion in write downs). Expect this to be a burden on the dollar and carry if the rumors hold water.

Outside of the significant, aforementioned event risk, the yen will continue to feel the breeze from concerns over a cooling global economy and fading interest rate expectations. Fears that the global economy is grinding to a halt continue to spread from the speculative realm to the policy realm. With realizations that the 2Q US GDP numbers aren’t likely to be repeated, the UK and Euro-Zone are heading for worse and Japanese growth numbers will be revised lower, the appeal of the high-risk, low-reward carry strategy will certainly disappear. What’s more, there a dovish turn in global interest rates is lower the return for staying with such a risky trade. If the RBNZ cuts for a second consecutive meeting, it will almost certainly lead to a sharp carry unwinding.

Jamie Saettele is a Technical Currency Analyst for FXCM.