Fundamental Forecast for Japanese Yen: Bearish

- Bank of Japan Strikes Dovish Tone, Keeps Policy Unchanged
- Japanese Firms Plan Record Spending Cuts in the Fourth Quarter

The US Dollar pushed sharply higher against the spectrum of major currencies last week as markets reacted to a decidedly upbeat interest rate announcement from the US Federal Reserve. Most significantly, Ben Bernanke and company said “deterioration in the labor market is abating,” which traders took as validation of the boost to the priced-in Fed rate hike forecast over recent weeks that was set off by better than expected outcomes for November’s nonfarm payrolls and retail sales reports. The US central bank is widely expected to look at the jobless rate as the key gauge for timing a reversal of its ultra-loose monetary stance, and a Credit Suisse gauge now shows that the market is pricing in 81 basis points in monetary tightening over the next 12 months, up from just 52bps at the beginning of December.

Meanwhile, the Bank of Japan struck a decidedly dour tone, saying the current momentum of self-sustaining recovery is insufficient and warning that overcoming deflation is a critical challenge, with the bank unwilling to tolerate CPI at or below 0%. The bank added that although the economy is picking up, the pace of improvement will be moderate until the middle of the 2010 fiscal year. This suggests the Japanese central bank may be starting to cave in to pressure from the Ministry of Finance to continue on with its liquidity-boosting asset purchase programs, a prospect that promises to underpin domestic bond prices and keep yields contained as the government issues a record amount of debt to finance the gargantuan fiscal deficit.

On balance, this monetary policy landscape seems to point to gains in USDJPY. Japan’s savings rate is high relative to other developed countries, reflecting the expense of living on an island with limited space and scarce home-grown resources. This translates into Japanese investors’ preference for safe, liquid assets that offer stable income over a long period of time. Typically, this means government bonds. While both Japan and the United States will have to introduce a good bit of new supply to finance their deficits, the latter will not have a central bank that is actively supporting prices and keeping a lid on yields. Indeed, the Fed ended its purchases of US Treasuries in October and looks to be laying the groundwork to begin raising borrowing costs next year. USDJPY is now 81.3% correlated with the yield on the benchmark 10-year Treasury note, suggesting that the currency may gain as traders digest last week’s updates to the US-Japan monetary policy balance.

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