Fundamental Outlook for Japanese Yen: Bullish

- The Bank of Japan cuts rates to 0.10 percent and announces plans to purchase commercial paper, more government debt
- Risk sentiment still volatile with $17.4 billion US auto bailout countered by downgrade of the broad financial sector
- Both the yen and dollar compete for position as the currency market’s top funding currency

Risk aversion is the key to the Japanese yen’s path over the next few weeks and into the beginning of 2009. However, the ebb and flow in market sentiment will be far from straightforward. Heading into the end of the year, liquidity will put an unusual spin on volatility and the demand for a safe haven currency. Historically, the currency market (like most others) will thin out substantially as traders exit the market in observation of holidays or to close the books for the accounting year. We have already seen such effects on activity this past week. The pullback in the massive bear rally in the US dollar is likely just such a pullback from extremes that comes with position squaring.

Looking at the major themes that have driven investors predominately to risk aversion over the past months, the markets will likely turn back to the hunt for a safe haven when liquidity is no longer warping conditions. Heading up this general market shift will be the outlook for growth. Most of the industrialized world’s third quarter GDP numbers have crossed the wires; and they have easily put the global economy on the path to recession. Far more concerning though have been forecasts for activity through 2009. Projections by central banks and governments (typically conservative prognosticators) are pointing to the most severe recession in decades for many countries. The greater issue however remains health of investor and lender confidence. With central bank’s offering virtually unlimited levels of liquidity and ever-expanding guarantees on funds, banks see little reason to take the risk in extending loans to each other or consumers. This has led to a conundrum where the basic operation of the global credit market depends upon these vital infusions, but it is simultaneously holding the progress back. What’s more, as long as this stalemate exists, financials institutions and major economic sectors will come closer and closer to failure. Just this past week, Standard & Poor’s announced it was cutting the credit rating of 12 major banks. With interest rates at record lows, the credit squeeze depressing asset values and consumer spending fading, the banking sector may be facing another round of bankruptcy scares and/or credit crunch. Add to that the threat of the major industries teetering on the verge of collapse (the US auto rescue package won’t go far); and the reign of pessimism will have to break soon if the global economy is to ward off disaster.

Ironically enough, the Japanese yen may actually find a greater (or at least more concise) reaction to scheduled event risk than the influence of risk sentiment. With low levels of liquidity naturally drawing the capital to safe havens through the end of the year, the market’s remaining event risk traders will be able to respond to the busiest economic docket among the G10. In the week ahead, the Bank of Japan will release its monthly report and the minutes for its November rate decision. The minutes will be interesting as it will better reflect whether the BoJ’s rate cut to 0.10 percent last Friday was due to the countries own fundamentals or in response to the Fed’s move towards zero. From a trading perspective however, the monthly report will be far more market moving with the group’s assessment of growth and financial conditions. Without doubt, Friday’s session holds the greatest weight over the market. Readings on housing, employment, consumer income, spending, inflation and industrial production are all scheduled for release. In general, this will be a good update on overall economic activity – though expectations should be restrained.

Antonio Sousa is a Currency Analyst for FXCM.