The Federal Reserve, in coordination with other central banks, has been taking a number of actions to stabilize financial markets. However, the U.S. economy will continue to face substantial challenges including further job losses, high energy prices and a rapid deleveraging in the financial sector. The Japanese yen could be the main beneficiary of the credit crisis and we expect more USD/JPY weakness going forward.

More Losses on Mortgage Backed Securities Could Mean More Gains on the Japanese Yen

There is a growing concern among international investors that any central bank measure will fail to restore investor’s confidence in the global financial system and given the current market environment of uncertainty and de-leveraging in financial markets, the U.S. dollar is likely to remain vulnerable against lower yielding currencies like the Japanese yen. The Federal Reserve has been taking a number of actions to increase liquidity and stabilize markets and the new bailout plan if approved, is likely to help the demand for housing in the form of lower mortgage rates. However, much more is needed since the U.S. economy will continue to slide until we see a much larger correction in the supply side of the housing sector in the form of lower prices. I will repeat something I have been saying over the last few days. Currently, the average American can’t afford to pay for a mortgage and there is something wrong with that. As a result, we are still far from reaching a bottom in the U.S. housing market and we may see more losses on Mortgage Backed Securities and gains on the Japanese yen.

The United States federal government deficit could reach $1 trillion. Investors expect that the recent efforts by the U.S. Federal Reserve to clean the market from some toxic assets could lead to a more general recover in the appetite for risky assets like high yielding currencies. However, some investors are concerned with the fiscal impact of the bailout plan which could cost almost 5 percent of GDP. Currently, the United States federal government runs a deficit of $438bn, or 3 per cent of gross domestic product and the bailout costs could push the fiscal deficit next year to $1 trillion or 7% of GDP.

David Rodriguez is a Currency Analyst at FXCM.