Fundamental Forecast for Japanese Yen: Neutral

The Japanese yen has once again started to deviate from its relationship with risk sentiment, re-coupling with the outlook for US interest rates. Indeed, a trade-weighted index of the yen’s average value against its major counterparts now shows a heavy correlation with the yield on the 2-year US Treasury note. The relationship makes sense considering the two currencies are both stand-by funding vehicles for carry trades. While benchmark Japanese interest rates are surely not going anywhere for the foreseeable future, those of the US will eventually rise as the Federal Reserve unwinds stimulus and other forces (discussed below) put upward pressure on borrowing costs. This makes US rates the barometer investors look at to gauge whether to fund yield-seeking carry positions with short-JPY or short-USD exposure, making them critical for the trajectory of the Japanese unit.

The week ahead offers plenty of opportunities for volatility in US yields, with all eyes naturally focused on the Federal Reserve monetary policy decision. While an overt change in interest rates or the QE2 program is almost certainly out of the question, policymakers’ rhetoric will be critical as markets shape expectations for what is to happen after the current $600 billion round of asset purchases expires in June. While Ben Bernanke and company have given no indication that they intend to unwind stimulus in a hurry, they have also shown no signs of favoring a so-called “QE3”, hinting Treasury prices are set to lose the inherent support from policymakers that kept yields capped since November of last year.

On balance, this promises to drive US borrowing cost expectations higher, particularly given the backdrop of the political battle over raising the government debt ceiling as well as the S&P downgrade of its credit outlook for the world’s top economy. On the other hand, Japan’s announcement of an “extra” budget for earthquake reconstruction that didn’t include new debt issuance may act as a counterbalance, as would the resumption of risk aversion (amid a litany of catalysts including the Euro Zone debt crisis, rising oil prices, and so forth) that sends capital into US Treasuries as a safe-haven asset.

A packed docket of US economic data releases compounds matters with Consumer Confidence, Durable Goods Orders and GDP as well as Personal Income and Spending figures standing out and bracketed by a ample supply of second-tier releases. All told, this makes for a deeply clouded landscape for US yields and the Japanese yen alike, albeit with the promise to shed light on where things are headed over the medium term once the deluge of information on tap actually crosses the wires and is absorbed by investors.

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