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Japanese Yen Awaits the Signal for Risk Appetite to Finally Reverse

Japanese Yen Awaits the Signal for Risk Appetite to Finally Reverse

Fundamental Forecast for Japanese Yen: Bullish

- Japanese Finance Minister Fujii says the government will fill the tax short-fall with greater debt issuance
- The interest rate outlook grows more extreme for USDJPY, yet the yen is retains its strength
- Does near-term USDJPY chop distract from a larger reversal in the making?

Though there has been some competition from the US dollar, the Japanese yen is still the market’s ideal funding currency for the recovering carry trade. With an overnight lending rate that is almost assured to maintain a discount to the Fed Fund rate and ample funds to attract investors looking to borrow and leverage on the cheap; it will only be a matter of time before the balance of power shifts and the stigma of the ‘low-yielder’ will shift back to its historical champion. And, considering the developments over the past few weeks, this could be a changeup that happens in the very near future. In the meantime, it will be imperative to keep a sharp on risk appetite. Though the dominant trend for those proxy gauges for sentiment are still overall bullish; momentum has clearly faded and many markets are still hovering at levels that are far off the mark that fundamentals would prescribe to them.

The most consistent (and therefore immediate) concern for trading the yen crosses is the measure of risk in the capital markets. Over the past month, the Dow (our proxy for the capital markets) has developed another counter-trend leg. What should really pop out is that, not only is this pullback the most prolific since the downswing in June/July; but the four prominent corrections of the past three months are growing more extensive. Taking market-based measurements like this is probably the better timing tool for a major turn because it takes a direct reading on positioning itself. In contrast, the markets have gone astray of fundamentals long ago; and the gap seems to grow larger each day. It is difficult to tell what will be the straw that breaks the camel’s back; but sentiment will be the primary driver for a meaningful reversal. When the market begins to unwind, panic profit taking will feed the selloff; and we will see just what percentage of the funds that have found their way back into the speculative arena are the type that are looking for yield and prepared to stick it out through the normal ups and downs reserved for short-term traders.

When risk appetite gets moving, the momentum will overwhelm most concerns; but we should not lose sight of the unique roles the currencies play in this market. Some currencies are high yielders that respond to a surge in risk appetite and others (like the yen) are key funding currencies that naturally depreciate as investors borrow (short) the unit to invest elsewhere. However, if the yen is the most robust carry trade currency; why does a chart of any of the yen crosses look so different from one of the Dow? There are a few factors that are altering this once close correlation. One of the key dynamic changes is the government’s record debt sales. Finance Minister Fujii has said that Japan would cover its lost tax revenue with an issuance of a record 132.3 trillion yen in government securities. This absorbs capital from the market (the capital that is usually put through to cross boarder traders). Another distortion is the US dollar. With a three-month Libor that provides a discounted yield to its Japanese counterpart; this currency is being treated as a cheaper funding currency (and every fraction of a percent counts when rates of return are as low as they are now). This is not a lasting situation, however; and we will soon see US market rates recover while the Japanese equivalents stay anchored.

Our final concern going forward is for economic data. There is little threat for volatility (much less a major turn) on the power of the listings through Friday. But, looking just through the weekend to the early Asian session on the 15th, we have the first reading of 3Q GDP. How aggressively is the Japanese economy recovering from its worst post-war recession? We will soon see.  - JK

Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@daiyfx.com

DailyFX provides forex news on the economic reports and political events that influence the currency market.
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