Fundamental Forecast for Japanese Yen: Bearish

The Japanese yen appears set for continued weakness as the leading drivers of the currency – risk sentiment trends and relative yield spreads – come into alignment to point the way lower for the already beleaguered currency. Indeed, the yen was the worst-performing currency in the five days through Friday, issuing the second consecutive week of losses and the worst one in 29 months. Looking ahead, the currency appears to have scope to finally break above 85.00 on USD/JPY, taking out the top of the range that has confined price action over the past six months and opening the door for a meaningful rally through the second quarter.

On the interest rate front, the noticeably hawkish turn in Federal Reserve rhetoric coupled with seemingly supportive fundamentals following an undeniably robust employment report in March has sent the US-Japan 2-year bond yield spread to the highest in two months. Judging by last week’s chatter from Fed policymakers, more of the same is likely on tap as the central bank releases minutes from the last meeting of the rate-setting FOMC committee. Markets have already taken notice, pushing a Credit Suisse gauge of the priced-in rate hike outlook over the next 12 months to the highest since June. On the other hand, the Bank of Japan is firmly on hold, with risks stacked to the downside as the world’s third-largest economy continues to battle the fallout from the Tohoku earthquake.

Turning to sentiment, the aforementioned positive cues emanating from the US promise to tip the scales in favor of risk appetite as hopes of firming recovery in the world’s top economy translate into a more optimistic outlook for global growth at large. With that in mind, the landscape is not without risks. Oil prices continue to march higher as the crisis in the Middle East stokes supply worries and Japan’s nuclear fiasco seems to be taking a turn for the worst. Furthermore, although markets shrugged off host of negative developments out of the Euro Zone last week as traders focused on the upcoming rate hike from the ECB, a “buy the rumor, sell the fact” scenario seems plausible as the blinders come off once speculation of imminent tightening is validated, opening the door for sovereign risk to rear its ugly head once more.

With that in mind, euro sellers may bide their time until the outcome of a EU finance ministers’ meeting in Budapest is revealed over the weekend, while a steady stream of Fed-speak (plus the aforementioned meeting minutes) keeps the focus on Bernanke and company and off arguably familiar (and to some extent, priced in) headwinds emanating from Fukushima and Tripoli. On balance, this suggests the path of least resistance favors continued Yen weakness.

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