Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Japanese Yen Weekly Outlook: Funding Currency Role May Limit Upside

Summary

USDJPY DAILY AVAFX CHART        12 FEB 12

Japanese Yen Outlook: Neutral/Bullish Short Term

USDJPY DAILY AVAFX CHART   12 FEB 12

-Events: Sun GDP m/m annualized, Tues BoJ Monetary Policy Meeting, Wed- BoJ Target Rate, Fri BoJ Monthly Report

- Yen follows risk appetite trends generated by Greek bailout hopes

- USDJPY maintains the general bias but lacks the momentum and volatility of other yen crosses

- JPY ‘s low likelihood of rate increases limits its appeal to that of a funding currency, which  helps it only as long as carry trades continue to unwind,

- USD’s long term appeal is  based less on unwinding carry trade, more on safe haven and ultimately rising yield appeal

-Thus long term USD/JPY outlook is bullish

Analysis

Over the short term, a funding currency for carry trade like the Yen, and a safe haven currency like the US Dollar, behave the same in periods of risk appetite and risk aversion. However, should markets be entering a phase of prolonged risk aversion, we expect to see better relative performance from the US Dollar

The Japanese yen’s perpetual low yield makes it a primary source of financing for the carry trade. Over the past 15 years, the benchmark yield that has backed the unit has remained near zero. Naturally, as global yields rise and risk appetite starts gains momentum, investors will look to take loans or build leverage in yen and invest elsewhere for a higher rate of return, thus they sell yen in times of risk appetite, and buy it back in times of rising fear such as the past months. Thus as long as there are carry trades that need to purchase Yen to unwind, demand for Yen will support the its uptrend.

In A  Prolonged Downturn, US Dollar Likely to Outperform the Yen

However, in a period of prolonged risk aversion, a distinct possibility given the EU debt crisis and  other threats to global recovery, carry trade unwinds and related Yen purchases finish. However, demand for a perceived safe haven like the US Dollar will persist as long as markets remain in risk aversion mode.

What conditions create prolonged periods of risk aversion? The interesting thing about a bear market is that any fundamentally driven crisis in confidence can rapidly snowball into an enduring market pullback. Witness, for example the slow but steady metastasizing of the EU credit crisis, from an isolated incident in Dubai to deep doubts over the continued solvency of Southern Europe and stability of the EU and the Euro. Its resolution will now require nothing less than a plan to assist the entire Southern European region and possibly other EU members, for though Greece may be the first country to face default this spring, the rest are close behind and will expect similar assistance. See Stocks, Forex, Commodities Outlook 2/15—2/19: EU Debt Crisis, Other Market Movers, and in Southern Europe Will Not Be Allowed To Default for details.

The former article noted above also details reasons why the current pullback in risk assets could be long lasting enough to allow the US Dollar, a more genuine safe haven currency than the Yen, to outperform the Yen.

While both currencies have pent up short interest from the 2009 build up; the yen doesn’t match the US Dollar as a  safe haven. Fundamentally, Japan is facing a more uneven economic recovery,  stronger deflation prospects and longer-term demographic  financial troubles than the US.

For this reason, we will have to watch the 4Q GDP figures due at the beginning of the week. While they may not offer much initial volatility given the market conditions when they are released; the implications for interest rate forecasts can generate a meaningful shift up or down the risk curve. 

DISCLOSURE: NO POSITIONS