Fundamental Forecast for Japanese Yen: Bearish

- Japanese Workers’ Earnings Fell The Most in Over 18 Years
- US Non-farm Payrolls Report Sends Japanese Yen Lower

The Japanese Yen looks set for sharp declines as economic fundamentals look set to re-capture the attention of the currency markets. The credit crises and subsequent global recession that erupted last year had introduced a new dynamic to financial markets, with virtually all asset classes locking into tight correlations on opposite sides of a directional bet on the direction of risk appetite. At times of risk aversion, this meant a stronger US Dollar and Japanese Yen; at times when traders less timid, this meant higher stocks, commodities and high-yielding currencies. Last week may go down in history as the key turning point when the market began to transition back from this “crisis dynamic” to more normal, macroeconomics-driven trading.

Currency markets seemed strangely complacent in the first week of August, showing next to no follow-though as five-month long rally in risky assets raced past major swing highs in the last days of July. Traders’ response to July’s better-than-expected US jobs report was a firm departure from crisis-induced patterns: stocks, carry trades, and the US Dollar all rallied while the Japanese Yen collapsed. The decoupling between the US Dollar and the Yen is most notable: we had long argued that the long-term US Dollar outlook would remain bullish after risk aversion faded on expectations that the States will be first to recover from recession having led the way into it, and this is precisely what post-NFP price action seems to have reflected.

The implications of fundamentals-driven price action spell trouble for the Japanese Yen. Median GDP forecasts from economists polled by Bloomberg suggest Japan will under-perform virtually every major industrial economy with the exception of the Euro Zone in 2009 and 2010. Consequently, interest rates are to remain at near-zero levels at least until 2011 even as most central banks begin to reverse course from extremely accommodative monetary policy in the second half of next year. This stands to inject a lot of life into the carry trade, with Yen remaining as the standby funding currency. While the global recovery is sure to be sluggish and there is little doubt that equity markets are overvalued having finished July at the highest level relative to earnings since October 2003, the Yen may be at the cusp of a major long term down trend.

Turning to next week’s economic calendar, the number of scheduled release is ample but none of them are likely to prove particularly market-moving. A larger current account surplus in June has been amply telegraphed by merchandise trade balance figures released two weeks ago. The Bank of Japan rate decision will surely prove to be a non-event considering policymakers have largely run out of policy levers that can be pulled and so are in a de-facto “wait and see” mode. Indeed, there is nowhere left to go on interest rates and broad-based quantitative easing has already been extended into 2010. A handful of sentiment surveys and June’s Tertiary index of service demand are unlikely to offer anything that is surprising enough to warrant meaningful exchange rate volatility.

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