Fundamental Outlook for Japanese Yen: Bearish

- Carry trade interest settles through low liquidity, but fundamentals still deteriorating
- Japanese yen finishes as the biggest gainer of the year despite the pull back in volatility
- Rate forecasts for historical funding currencies works in favor of the safe haven yen

Heading into the close of this past week, the yen finally lost its bullish grip against the US dollar. In fact, the Japanese currency has been losing ground against most of its liquid counterparts for the past two weeks, though this is likely more a manifestation of the thin liquidity conditions during this that period rather than any true turn in risk appetite. With the markets expected to once again hit full capacity this week, this theory will be pivotal in defining the strength of the yen and the outlook for general risk trends.

From a sentiment perspective, the USDJPY’s push through a long-term falling trend will be a significant driver for yen bears everywhere. Should this pair find significant follow through, it could very well drive trigger comparative breakouts in other crosses. Fundamentally, investors will come back to the market rehashing the same questioned that plagued sentiment through the second half of 2008: is the end in sight for the financial crisis; and how severe will the global recession be? Looking at the events that have transpired and data that has been posted over the past few weeks and months – the answers are not likely to impress. For growth standpoint, it is clear that consumer spending has taken a severe turn for the worst. As the largest element of growth, signs that wealth, income and employment are contracting merely lowers the expected turning point for the economy. In turn, the ongoing slump in economic activity will further depress returns and raise the bar for risk aversion. What’s more, growing uncertainty in the financial markets is already weighing on sentiment. Over the past few weeks, the US government was forced to bailout its auto sector. This seems to have plugged the hole for now, but there is no doubt that other American industries are on the brink of collapse and it isn’t much of a stretch to suspect that other economies are in the same predicament.

With a rebound in risk aversion, the Japanese yen will likely be the primary benefactor – as it has been for the past few weeks. Furthermore, barring a severe seizure in the money market liquidity, the yen will continue to find the safe haven flows that had initially migrated to US treasuries. With volatility currently off its highs, investors will feel more confident in questioning the near-zero returns from holding US government debt. And, filling this void, fundamental speculation of a burgeoning recession for the world’s largest economy will further build on the dollar’s ‘oversold’ status. However, there are also major forces that can work against the Japanese yen. For the week ahead, a momentous rebound in equity and other capital markets could work against this habitual carry proxy. Less likely - but surely a concern – is the possibility of BoJ intervention. The central bank does not usually report its activity in the market until well after the fact, but they have proven themselves to be consummate traders in the past and capable of encouraging significant reversals in their own right.

Jamie Saettele is a Technical Currency Analyst for FXCM.