Fundamental Forecast for Japanese Yen: Neutral

The US Federal Reserve’s reboot of quantitative easing (QE) stands as the central driving force behind Japanese yen price action, albeit in two distinctly different ways. Twenty-day percent change correlation studies reveal USDJPY price action is torn between its long-term link with the US-Japan bond yield spread and a rejuvenated inverse relationship with risk appetite. This leaves the door open for a variety of outcomes in the week ahead.

As we discussed in our weekly forex trend monitor, Ben Bernanke and company delivered just about what the markets had been expecting, leaving traders without a renewed catalyst to drive the rally in risk appetite that began in August when policymakers first introducing the idea of additional stimulus at the central bankers’ summit in Jackson Hole. This has left the door open for some much-needed retracement on the back of profit-taking into the end of the year. Indeed, in the first week following the QE announcement, the safety-linked US Dollar rose while stock markets sank, both by the largest margin since the five days ending August 13. Considering the newly strengthened inverse correlation between USDJPY and the MSCI World Stock Index, a continuation of this dynamic points to yen strength as a broad-based pullback across the spectrum of risky assets stocks gains in the perennial funding currency.

All is not cut and dry however considering relative yields remain important, with USDJPY still showing a close correlation to the 2-year US-Japan rate spread. The Fed has officially started buying securities, meaning US yields are due to come under pressure. Meanwhile, the Bank of Japan is topping up its own QE efforts with a 5 trillion yen asset purchase fund. Interestingly, the 2-year yield gap has shifted decisively in favor of the US Dollar since the Fed QE announcement, hinting the BOJ is likely to outdo its American counterpart and pointing toward USDJPY upside.

On balance, the outlook for the yen looks clouded as it remains uncertain which reading of the post-QE landscape proves dominant in the week ahead. We suspect the currency will rise against most of its major counterparts on risk aversion with the solitary exception of USDJPY, where we suspect the Dollar will prevail with the yield spread seemingly as due for a retracement in favor of the greenback as sentiment at large.

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