Fundamental Outlook for Japanese Yen: Bullish

-- Fears arise that emerging markets may begin to default on sovereign debt, adding fuel to the fire
-- Data confirming a global recession is sweeping over the market
-- Government bailouts and unlimited short-term funding can’t curb the market’s need to deleverage

Following on a volatile end to an incredibly strong week, Japanese yen traders’ first thought upon the return of liquidity after the weekend should be "what is the level of risk sentiment in the market?" Should the world’s policy makers proffer another coordinated effort to encourage calm in the markets, an overextended yen could see a sharp pull back as general risk appetite finds its way to a relief rally. Beyond a temporary pull back in fear, fundamental interest in the Japanese currency will take its lead from the ongoing drop in investor sentiment and capital markets. While the trillions of dollars of losses in asset value across the markets this past month has leveraged the demand for the yen, there is more of a fundamental basis for the currency’s appreciation than mere panic. Beyond the multi-year lows and record breaking declines of the world’s premiere share indices, all market participants are merely trying to deleverage from massive positions that are quickly taking on water. In the currency world, no where was leverage more abused than in the carry trade.

What’s more, even should carry interest peter out (which it won’t), capital will continue to flow into Japan as it represents one of the most fiscally sound nation’s in the world and the second largest economy – therein a safe place to harbor capital. As the global economy further tips into a recession, traders will further reassess where to place their funds. Next week, the US is expected to follow the UK by confirming a contraction in economic activity through the third quarter. While the dollar will nonetheless retain its safe haven status, confidence will still be marred in the US dollar. Subsequently, number two Japan will seem a good place to diversify, just in case.

The only scheduled economic data on the Japanese docket in the week ahead with any sort of tout is, oddly enough, the Bank of Japan’s rate decision. The central bank hasn’t cut rates since 2001 and the benchmark has held at or below 50 basis points for thirteen years now; but a shift from policy makers now would suggest they are running out of options. The BoJ essentially has no capacity to revive the markets through traditional monetary policy means – the same situation they were in following the 1997/1998 financial crisis. From a primary lending rate of 0.50bps, they could cut very little; and even at zero (ZIRP), we have seen that the economy and investment trends have suffered even during the best of global economic conditions. This will be a very important contingent to watch going forward to gauge the long-term strength of Japan, its assets and its currency.

David Rodriguez is a Currency Analyst at FXCM.