Fundamental Forecast for Japanese Yen: Bearish

- Yen follows risk appetite trends that follow the progress on a possible Greek bailout
- USDJPY maintains the general bias but lacks the momentum and volatility of other yen crosses

There is a critical difference between a currency that is driven by its funding status in the carry trade and one that is treated as a safe haven. On the surface, the two may seem the same since they have recently produced the same end result. A clear example can be drawn from the Japanese yen and the US dollar; both of which have established considerable bull trends over this past month thanks to a strong pace behind the recent wave of risk aversion that has washed over the markets. However, it is critical to discern the differences between these two roles; because the yen’s continued strength is fully dependent on one and threatened by the other.

Currently, when there is a strong move towards risk appetite or risk aversion; the cumulative effect on a funding currency and safe haven currency are the same. Yet, should sentiment begin to flag and stabilize or background fundamentals begin to shift, the differences between the two will start to show through. For the Japanese yen, it is safe to label the currency a primary source of financing for the carry trade. Over the past 15 years, the benchmark yield that has backed the unit has remained near zero. Naturally, as global yields rise and risk appetite starts gains momentum, investors will look to take loans or build leverage in yen and invest elsewhere for a higher rate of return. Throughout the past year, worldwide interest rates may not have climbed; but speculative appetite has recovered and encouraged a dramatic build up in carry outlays. Currently, investors are realizing that growth and expected returns are developing at a protracted pace; and many have found themselves stretched in terms of risk. And, considering the sheer influx of speculative fund over the past year; there is plenty of room for the yen to continue to appreciate should market participants continue to unwind their risky positions.

Where will the winds of risk aversion originate? The interesting thing about a bear market is that any substantial crack can turn into a canyon. Over the next week, the most threatening dynamic to general market stability is the European Union’s bailout plan for Greece. The group has already generally committed to offering aid; but they have yet to decide exactly what the rescue will entail. Policy makers would prefer to restore confidence in the country’s own efforts to cut its deficit and generally recover. However, concern over the broader stability of the Euro Zone will likely render that option unviable. Therefore, policy makers will need to develop a plan that is definable, quantifiable and does not invite moral hazard. This will be a difficult benchmark to meet. Furthermore, should an answer be made for Greece; there are any number of potential backups for feeding fear (Portugal, Spain, China, US and the list goes on).

There is plenty excess premium and a glut of fundamental problems behind the market to keep the risk aversion current strong. However, at some point, the carry interest that has been built up through the Japanese yen will meet a point of equilibrium (a level where the rate of return on a spread trade is stable enough that the additional risk is compensated for). When that level is hit, the yen’s advances will stall. Yet, at the same time, the US dollar could continue to gain. The reason for the different paths is the latter’s appeal as a safe haven. While both currencies have pent up short interest from the 2009 build up; the yen doesn’t quite fit the bill. Fundamentally, Japan is facing an uneven economic recovery, deflation and long-term financial troubles. It is for this reason, that 12-18 months out, it is not difficult to imagine Japanese rates still holding at zero. A long-term carry candidate will respond less to short-term risk aversion as investors see the potential. For this reason, we will have to watch the 4Q GDP figures due at the beginning of the week. While they may not offer much initial volatility given the market conditions when they are released; the implications for interest rate forecasts can generate a meaningful shift up or down the risk curve.

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