Yen Strength Costs Japan Dearly; Dollar Poised to Extended Gains

Japan has not been having a good week so far and the pain is set to continue. Japan reported much weaker than expected growth for the second-quarter early in the week and subsequently China overtook it as the second-largest economy in the world, after the United States. Early this morning Japan reported a massive loss for their special foreign exchange account due in large part to the yen’s recent bout of strength.

While the Bank of Japan maintains that the yen’s rise doesn’t pose an immediate threat to the real economy, yen strength is costing Japan dearly. This mornings report showed that the recent rise for the yen has led to a record 31 trillion yen ($362 billion) valuation loss for Japan’s foreign exchange account. The nation’s foreign exchange balance is now 20.6 trillion yen, showing that that 31 trillion yen loss cost Japan a huge portion of its reserve holdings. Despite this incredibly steep price paid for yen strength Japanese officials appear to be in no rush to counter yen strength and comments out of Japan have been vague and indirect and subsequently have been largely ignored by the market.

Japan’s Prime Minister is slated to meet the central bank governor on Monday to discuss further stimulus measures which would materially weaken the currency. The central bank has said that it is prepared to consider further easing of monetary policy if the currency surges further or political pressure increases. It is widely understood that the Bank of Japan has a ‘line in the sand’ at the 85.00 yen to one US dollar level, any extended move below this level will invite action from the administration. We feel it is worthy of note that some former central bank officials have commented this weak that options are limited for the administration and the United States is unlikely to approve of direct intervention in the currency market. We will continue to watch developments keenly, however, after Japan already paid a very steep price for yen strength the ammunition left in its armory is already diminished and they surely will learn from the mistake made by the Swiss National Bank who tried to fight franc strength at a cost of billions of euro, a fight they ultimately lost.

Japan’s major trading partner, the United States, is finally seeing its currency find its feet after weeks and weeks of being brutally sold as the recovery in the US faltered. The dollar index hit an inflection point in the last week as it carved out a base near the psychological 80.00 level and started to move higher again. While the US economy is not looking much better the move higher has been driven by investors seeking safety as the global recovery is thought to be at risk amid slowing Chinese growth. We believe that the dollar will continue to gain, specifically against higher-yielding currencies, such as the Aussie and Kiwi, as investors pile into safe haven assets.

We also feel that the euro is very vulnerable to the downside as we have seen in recent days, amid rumblings about financing concerns in Ireland and Spain. The euro-region is certainly making progress but we contend that if the debt crisis is being resolved by issuing more debt the EMU remains susceptible to shocks. As such the dollar is well positioned to make gains against the euro over the third-quarter. That said, we maintain that the US economy stands at a cross-roads whereby we will see a significant acceleration in growth throughout the second half 2010, or the economy will stall out and ultimately slip back into recession, which may ultimately cap the amount the dollar can gain against the euro specifically.

It is our position that now the dollar has regained is safe-haven status it is ripe to extend gains in any situation. Meaning, that if the US recovery starts to gather momentum, safe haven plays will be unwound but speculative players will enter dollar positions in anticipation of rate hikes and the narrowing of yield differentials. But if the US economy – and the global economy – continue to grow at a snail-like pace or slip back into recession the dollar will rise on safe haven plays. While our outlook for the dollar is bullish, we caution against entering positions that pit any two safe haven currencies against each other, our expectations for dollar gains against the yen, for example, are extremely limited in the short-term as the yen remains a highly sought after save haven.

Written by Jonathan Granby, DailyFX Research Team

If you wish to contact the author with comments or questions email jgranby@fxcm.com