Fundamental Forecast for Japanese Yen: Neutral

The Federal Reserve’s reboot of quantitative easing (QE) earlier this month remains the driving force behind yen price action, albeit in two distinct ways, hinting the Japanese currency is poised to rise against most of its major counterparts while trading lower against the US dollar.

Ben Bernanke and company delivered just about what the markets had priced since policymakers initially floated the idea of renewed stimulus at the Jackson Hole central bankers’ summit in August, robbing the subsequent four-month rally across the spectrum of risky assets of the impetus to continue and opening the door for profit-taking. Over recent weeks, this underlying tendency toward risk aversion has found added fuel in a toxic mix of geopolitical and sovereign risk as North Korea shelled its southern neighbor while the Euro Zone continued to struggle with festering debt problems on its periphery.

More of the same is likely ahead after KCNA – North Korea’s official news agency – said “escalated confrontation” would lead to war on Friday, adding it was “ready to give a shower of dreadful fire and blow up thebulwark of the enemies.” Meanwhile, bad news continued to flow out of Ireland where the ruling Fianna Fáil party lost a key by-election in Donegal South-West, narrowing its majority in the lower house of parliament (the Dáil) from three to two seats and threatening the passage of its budget on December 7.All this coupledwith the specter of a slowing growth in China– the world’s second-largest economy and Japan’s top export market – after reserve ratios rise 50bps on Mondayhints the path of least resistance points lower for the spectrum of risky assets, spurring an unwinding of carry traders funded cheaply in yen and boosting the currency against most of its higher-yielding counterparts.

Sizing up the Japanese unit against the dollar amounts to a different matter, however. Indeed, the very same QE expectations that drove risky assets higher since August had also weighed heavily on US bond yields. This drove USDJPY lower as a narrowing in the US-Japan yield spread in favor of the yen pushed traders to diversify into carry trade positions using the greenback as a funding currency. With QE now in place, this yield spread has staged an analogous correction to that seen in risky assets, rising by a whopping 11.3 basis points (58.1 percent) since the beginning of the month and pushing USDJPY to end last week at the highest level in two months. This dynamic is poised to remain in force as the broad-based unwinding of QE-linked bets continues, pushing the yen lower against the dollar even as it scores gains elsewhere.

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