Fundamental Forecast for Japanese Yen: Mixed

The Japanese yen looks ahead to a volatile week as the currency’s lingering correlation with US Treasury bond yields and sensitivity to risk sentiment trends puts it squarely at the epicenter of major event risk. The pressure begins to mount over the weekend as Greek Prime Minister George Papandreou stands for a confidence vote and carries swiftly into Monday as EU finance ministers gather for a summit in Luxembourg in an attempt to lay the foundation for a fruitful meeting of the region’s heads of state on Friday. In the interim, the Federal Reserve is up to deliver its monetary policy announcement, the first since calling an end to QE2, on Wednesday.

Looking first at the situation in the Euro Zone, things looked a bit better at the close of trade on Friday than they did most of the week after German Chancellor Angela Merkel backtracked on asking private investors to play a “substantial” part of any new Greek aid efforts – a position that scuttled talks between Euro Zone finance ministers last week – saying any such participation would be voluntary and taken up with the agreement of the ECB (which has vocally opposed it, fearing it would amount to a de-facto default). Merkel issued the statement alongside French President Nicolas Sarkozy, thereby telegraphing that the core Franco-German axis that steers EU policy was in agreement on the matter.

Coming together at the last possible moment to avert disaster and cobble together a compromise is a familiar way to get things done in the EU. Indeed, the regional bloc was always an arrangement of primarily political rather than economic expediency, so some kind of arrangement to get through the current crisis and make sure the region’s structural integrity is not challenged was bound to emerge. While it certainly solves none of Greece’s core problems, a relatively credible setup that pushes resolving the issue far enough down the road is likely to be met with optimism in the financial markets, with the subsequent upswing in risk appetite likely to weigh on the Japanese Yen as traders re-enter carry trades funded cheaplyin the perennially low-yielding currency. With that said, there is always the possibility that this time is different and a tangible agreement is not reached, but that is a risk to the dominant scenario rather than the path of least resistance.

As for the Federal Reserve, significant policy changes are essentially off the agenda after the end of QE2 was cemented just last month, with traders turning their attention to the tone of the rhetoric accompanying the announcement as they attempt to reconcile increasingly hawkish posturing from a number of Fed officials (including Plosser, Fisher and Kocherlakota) with the neutral-dovish approach taken by Ben Bernanke himself. As last month, this puts the spotlight on the press conference that the Fed Chairman will hold after the rate decision as well as the presence of a promise to keep rates low for an “extended period” in the policy statement. As if things were not complex enough, two interpretations are possible here: a dovish posture may weigh on US yields and pressure the Yen higher, but if that is taken as a positive development for risk appetite the Japanese currency may yet find itself on the defensive, and vice versa.

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