Fundamental Outlook for Japanese Yen: Bearish

- Risk and carry trends coming to a crossroads as failing growth and government stimulus square off
- A USDJPY breakout could redefine long-term direction between these two safe haven currencies
- The US steps up its bailout efforts yet confidence in growth and financial markets is little moved

How long will the market demand a safe haven? This is the question on most investors minds regardless of their asset class or trading method. Perhaps a more interesting question for the FX market, however, is how long can the Japanese yen retain its position as the favored safety of funds currency. These will be the key drivers for the yen over the coming week and beyond.

There isn’t much room (or time for that matter) for traders to think critically about the more complex fundamental questions surrounding the Japanese yen this weekend as the first measure of fourth quarter GDP is scheduled for release first thing Monday morning in Tokyo. Rarely does a regular, scheduled economic indicator threaten to move market; but this reading certainly has the power. Economists are already aiming low by forecasting a 11.6 percent annualized contraction for the world’s second largest economy through the end of 2008. Such a slump dwarfs the 1.2 percent contraction in the Euro Zone, the 1.8 percent slump in the UK and even the 3.8 percent slide in the US. So, to put the data on a more even playing field, we can measure it up to its own historical performance. Should such a number be met, it would confirm the worst recession since the 1974 oil crisis.

It is not a stretch to come to the same conclusion when benchmarking the number ourselves. Foreign demand has vanished as global spending has disappeared; and domestic consumption was struggling even during the recent boom years. However, looking beyond the historical significance of this data, it is important to keep in mind the warnings issued by the Bank of Japan’s head researcher Kazuo Momma. He warned this past week that the contraction through December “may have been unimaginable,” but the more disturbing comment was that the market should be prepared for an even greater slump through the first quarter of this year. This leaves traders to wonder how long Japan’s recession will last. Even when global growth does start to turn, it will likely be a drawn out and cautious shift; and there is little to expect from domestic anemic domestic spending. If this is the case, investors will start to wonder why the yen would be considered during a flight to safety. Low interest rates aren’t unique and safety of funds is severely compromised if Japan heads into another crisis where its banks are labeled technically insolvent.

A fading correlation between the yen and risk appetite will likely take time; and it may not be prudent driver for price action through near-term. More pressing will be the overall level of sentiment among investors. Should, risk appetite improve, the debate over the best safe haven is irrelevant. Confidence has certainly not returned amongst speculators; but the groundwork has been laid. From the markets, the yen crosses and equities have been confined to congestion since November; money market rates have begun to improve and there has been a notable shift in capital towards those safe investments with some level of return. From a more tangible standpoint, governments have made drastic efforts to thaw credit and hold up their own markets. Conditions will truly turn when confidence among consumers and investors improves; and it may be only a matter of time before these economic participants yield to the loose but global effort being made to turn things around.

Jamie Saettele is a Technical Currency Analyst for FXCM.