Yen Becomes Increasingly Vulnerable As Risk Appetite Grows

USD/JPY

The Japanese Yen was lower on the day as several consumer related names including Walt Disney and Abercrombie & Fitch gave improved outlooks, fueling risk appetite. The upbeat earnings reports came on the heels of Hewlett Packard’s better than expected results and their announced merger with 3com. Equity markets continue to find support on the back of healthier bottom lines, as they look past the implications of rising unemployment. The USD/JPY’s correlation with risk has held steady at 18% as the Fed’s commitment to keep interest rates low has maintained the dollar’s status as a funding currency. For this reason we have seen U.S. interest rate expectations explanatory powers over the pair slip to 7% from 13% a week ago. U.S. fundamental have become the key for the pair as an improved outlook for growth would raise interest rate expectations and restore risk sentiment’s influence over price direction.

BoJ Interest Rate Expectations

Overnight index swaps continue to price in between 5 to 8 bps of rate hikes over the next twelve months as the BoJ traditionally maintains an accommodative policy. The central bank’s desire to limit yen appreciation in order to spur demand for exports will keep them on hold for the foreseeable future. Additionally, the central bank has predicted that he economy will remain in a deflationary period for the next two years making it prohibitive for them to raise rates.

FOMC Interest Rate Expectations

Markets continue to lower their interest rate expectations for the U.S. with Fed funds futures now pricing in a 4.5% chance of a rate hike in January. Several committee members have expressed the central bank’s willingness to remain on hold as they determine the longer term implication of the credit crisis. The University of Michigan consumer confidence reading unexpectedly fell to 66.0 from 70.6 as the weak labor market continues to weigh on Americans minds. The U.S. retail sales report on Monday will show whether the dimming outlook is impacting spending habits as we enter the critical Holiday shopping period. Signs of sustainable domestic spending could raise inflation expectations and shorten the time horizon for Fed tightening.

Risk

The Dow is testing the 50.0% Fibo of the 14,198-6469 decline which may prove to be a formidable resistance level. Policy makers have continued to warn that the global recovery remains fragile and the possibility of another contraction may limit any further advance from stocks. However, a break above resistance leaves potential to 11,245-61.8% Fibo, where we also see former congestion. Fundamentals would have to significantly improve to generate that level of support. The USD/JPY would most likely benefit from the increase optimism if the greenback lost its status as a funding currency on the back of increasing interest rate expectations.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com