Fundamental Forecast for the Japanese Yen: Neutral

The Japanese yen lost ground against the U.S. dollar as rising yields for U.S. Treasuries sparked increased demands for the greenback, but the exchange rate is likely to face increased volatility over the following week as the Federal Reserve convenes for its last interest rate decision in 2010. As the recent rally in the USD/JPY fails to produce a test of the November high at 84.39, the exchange rate is likely to consolidate going into the following week, and dovish comments from the FOMC could generate a bearish breakout in the dollar-yen as Chairman Ben Bernanke sees scope to conduct additional monetary easing.

As the central bank head casts doubts for a sustainable recovery, the Fed is likely to maintain a cautious tone in regard to the economy, and speculation for further easing could intensify over the coming monthsgiven the ongoing weakness within the private sector. In addition, we should see the FOMC maintain its pledge to keep the benchmark close to zero for an “extended” period of time as it aims to balance the risks for the region, and the central bank may take additional steps to stimulate the ailing economy as growth and inflation remain subdued. In turn, the central bank could show an increased willingness to widen its balance sheet further, and expectations for another expansion in quantitative easing could trigger a selloff in the U.S. dollar as investors weigh the prospects for future policy. At the same time, the Fed may attempt to curb the recent rise in U.S. Treasury yields, which could translate into dollar weakness, and comments from the committee is likely to set the tone for future price action as the economic outlook remains clouded with uncertainties.

With the USD/JPY carving out a near-term top in the beginning of December, the FOMC rate decision could lead the exchange rate to retrace the advance from the previous month, and a marked appreciation in the Japanese yen could reignite speculation for a currency intervention by the Bank of Japan as China looks to tighten monetary policy ahead of 2011. As the rise in global trade cools, with the Japanese economy struggling to brush off the economic downturn, the BoJ may look for alternative measures to stimulate the economy, and the central bank may face increased pressures to weaken the national currency as policy makers aim to support an export-led recovery.

DailyFX provides forex news on the economic reports and political events that influence the forex market.