Fundamental Forecast for Japanese Yen: Bullish

- Final reading on 2Q GDP reports a smaller than expected 2.3 percent pace of expansion
- Cabinet Office says “economy is showing movements of picking up” and lists record unemployment as a difficulty
- Is USDJPY oversold after this past week’s plunge to seven-month lows?

After a strong surge in risk appetite through much of the week, the market finally broke from momentum this past Friday. However, we can’t call this stall a reversal – at least not yet. Gauging the overall sentiment in the market, we find that the benchmark Dow is just off 10-month highs, the dollar set a new low for the year and money-market funds are at their lowest levels since late October of last year. All signs are still pointing to a healthy appetite for yield with relatively little concern for market disruptions. However, the fundamental quality of this rally looks more and more bleak when compared to the fresh highs these assets reach with each week. How far can this divergence extend? That depends on how stable risk appetite is.

There is little doubt that a demand for capital returns is leading the markets higher. For those assets that are considered low-risk or risk-free, we can see yields are still brushing recent historical lows. With the risk-premium of a possible financial crunch left out of the equation, we are left with a reflection of growth potential and an outlook for benchmark lending rates. Considering the generally accepted forecast for a protracted and choppy recovery, it is no wonder that the rate of return is so low. In contrast, capital markets have measured a six-month advance that has paid off with capital gains for earlier adopters. However, when expectations for steadily appreciating speculative securities dies down, we may very well see a wave of profit taking that gathers more momentum than the advance that brought us to our current highs. How long can sentiment build on itself? That is impossible to tell. There is – theoretically speaking - enough fuel to keep the trend going until the fundamental backdrop improves. The money that has been sidelined in Treasuries, money markets, savings accounts and other low-risk coves is only a six to eight month off the highest levels seen in recent memory. For scale, the ICI Investment Company Institute’s measure of total assets in money market funds was at $3.54 trillion at the close of last week – less than 10 percent off its January highs. On the other hand, the limited drawdown in safety funds to this point suggests caution is still the rule of thumb. After a record collapse in cumulative wealth after last year’s financial crisis; it wouldn’t take much to cut the flow of capital from the sidelines off and encourage speculators to take profits.

Another consideration for yen traders that perhaps does not receive enough attention is the unwavering correlation between the Japanese currency and risk appetite. The Japanese yen has retained its status as the primary safe haven currency among the majors thanks to the abundance of funds in the country and a forecast for interest rates being held near zero for far longer than other countries that are just waiting for inflation to perk up and growth stabilize a little more. In the background, though, the Japanese economy will struggle to recover from its record recession and the damage to its already weak financial markets can be long-lasting. Already, we can see that many of the yen crosses are still carving congestion well off recent highs despite the fact that equity benchmarks are climbing higher.

The yen’s link to risk is particularly important for USDJPY. The dollar was considered a safe haven through the worst of the financial crisis thanks to the liquidity and securities of US Treasuries – and yet, the yen maintained its negative correlation to risk trends even against the greenback. It is unusual then that over the past four weeks, USDJPY has steadily plunged nearly 800 points when risk appetite has invariably risen. Long-term risk appetite, policy views (the Japanese want cheap exports) and interest rate forecasts (the Fed has put a hold on rates to mid-2010, but the BoJ hasn’t even discussed hikes) all favor the dollar over time. But, in the meantime, the benchmark three-month US Libor rate is at its lowest level on record – and subsequently at a discount to its Japanese counterpart.

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