Fundamental Forecast for Japanese Yen: Bearish

- The market has maintained its bullish drive; but will we reach a fundamental and technical extreme?
- Is the dollar the top funding currency?
- Will the yen’s reversal develop into a more progressive trend?

What is the most influential driver behind the Japanese yen? The same underlying current for all capital markets: risk appetite. It used to be the case that the yen’s relationship to market sentiment was one of the most straightforward fundamental relationships that the FX market had to offer. When the market found its appetite for yield, the currency would be sold against counterparts that bore better interest rates. And, when fear gripped the markets and traders want to abandon their risky positions, the yen would appreciate. However, this most basic of relationships has changed in recent weeks. The yen is no longer saddled with the burden of being the top funding currency for the ever-present carry trade. That leaves us with a few questions to sort out next week’s price action: which direction will risk appetite take; how will the yen respond to sentiment trends; and will more traditional fundamentals fill in the fundamental hole?

To answer the first question, we saw a faltering in risk appetite through the end of this past week; but it certainly wasn’t a reversal. In fact, the seven-month rise in optimism looks as stable and strong as it ever has. However, the fundamental drag on this speculative run could soon tip the scales. Capital is still finding its way into the market – and there is a lot of sidelined money to be reinvested – but the major of those funds that are still in relatively ‘risk-free’ assets below to those that are skeptical of the rally to this point or need true interest income rather than the promise of capital gains. Since much of the capital that has returned to the speculative space to this point is looking to ride the steady rally; there is significant risk that a modest pull back could trigger a wave of profit taking that develops a new trend. Does that mean this will happen next week? No. However, a catalyst could certainly move up the time-table for such an outcome. The third quarter earnings season in the US holds this kind of influence. So far, the numbers have been hit-or-miss. Non-financials show the real trajectory of growth (and the comparisons to activity just two years back shows how weak conditions truly are); but the banks are what traders are really looking at. Earnings have surprised for Goldman Sachs and Citigroup; but the first owes its income to trading and the second is likely rolling loan losses into the future. Bank of America’s reading was likely the better reflection of the real health of the group. A $1 billion loss was led by significant lending right offs. If write downs are just being pushed backed and loan loss reserves not bolstered, the pain is just being delayed.

The next question we have to ask is whether the Japanese yen has flipped its response to risk trends. We saw USDJPY rally over the final days of this past week when sentiment stabilized and pulled back somewhat. However the yen has not abandoned its funding currency status. Taking a look beyond current conditions (where the Japanese Libor is at a premium to the United States’), the Japanese rate is likely to be held at near zero for the longest of its peers. What’s more, the availability of funds is no doubt going to be much higher for Japan. A naturally high savings rate, loose monetary policy and deflation are all buffers of cash.

But, in the interim, should we expect regular fundamental event risk take over for price action? Well, considering the direction the yen held over the final two days of last week when the Bank of Japan and Cabinet Office upgraded their economic forecasts, there is a low probability that data will offer too much guidance. Besides, there are few major market movers scheduled for release on the docket.

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