Fundamental Forecast for Japanese Yen: Bearish

We don’t often have the ability to test the capabilities and mettle of the world’s policy authority; but we can see just that with the Japanese yen. On the one side, we have the G7 and its commitment to maintain a stable Japanese yen exchange rate - and though they won’t necessarily admit this associates to a specific level, it almost certainly does. And, in the other corner we have the cumulative interests of the world’s capital markets. Who will win? Is the equation that simple? The answers to these questions will determine whether we see the yen’s retracement turn into a long-term bear trend or transition into yet another strong rally.

Not long after the market started to garner a loose understanding of the economic and financial toll (not to mention loss of life) of the nation’s worst earthquake on record, Japanese capital markets tumbled and dragged global investor sentiment with it. And, it is in this move to unwind risk positions that the Japanese currency rallied. As the FX market’s primary funding currency, the yen actually appreciated as the country’s pain unfolded. This relationship caught many off guard; but it is an fundamental driver for the currency. That leads us to the question: who has more pull in the market – the central banks of the G7 or investors the world over? It isn’t even a contest. The market is far too large for this group to make more than a dent. Furthermore, they wouldn’t likely make much of an attempt even if they did intervene – we refer to the pitiable effort they made in their first coordinated effort.

And so, we await risk appetite trends. We can at the usual barometers and fundamental catalysts. The S&P 500 is a favored gauge as it represents an additional layer of buoyancy – a deep layer of stimulus. For catalysts, we can point to tempered expectations for global growth, fears that the aggressive capital inflows into emerging markets will be reversed, a serious deterioration in the European Union’s financial health and the economic impact of the trouble in the Middle East and North Africa among other issues. The list is a long one; but we gaining the market’s attention is another matter. Sentiment has a tendency to maintain its course through sheer momentum.

With the risk in mind, we should also consider the unique performance of different groups of yen pairs. For AUDJPY, NZDJPY and other high-yield currency pairs; a reversal in risk appetite will have a clear and strong impact on the carry flow. However, the same argument doesn’t really hold for a pair like USDJPY. Given the near-zero rates in the US, there was little incentive to build carry on a long USDJPY position and the abundance of stimulus in the US means there is as much negative pressure in the dollar as the yen. Furthermore, the G7 has an explicit focus on this second most liquid currency pair in the world. So, while the G7 would be largely ineffectual in a case of market-wide risk aversion, they could actually carry significant weight for USDJPY specifically.

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