USD/JPY 2007 Second Quarter Outlook

In the first quarter of 2007 the Japanese yen went on a rollercoaster ride as USD/JPY first verticalized to 122.21 taking out multi-year highs only to quickly collapse to 115.14 before settling down at the 118.00 essentially the same level where it began the year.

The seesaw price action in the pair was driven more by the flow in and out of the carry trades rather than actual Japanese economic performance. Nevertheless, the Japanese economy aided by favorable exchange rates, produced strong results as the corporate sector continued to register healthy profits while the long suffering Japanese consumer finally showed a willingness to spend. However, the pick up in economic activity translated into only one rate hike from the BOJ as Japan maintained the lowest interest rates in the industrialized world of only 50bp. Furthermore, Japanese monetary authorities continued to stress the fact that any incremental tightening will continue to be gradual, thus leaving the unit vulnerable to carry trade sales pressure. On the other hand, the currency saw a very strong rally at the start of March, gaining 700 points in a matter of days as the meltdown in global equity markets created a massive wave of carry trade liquidation and speculators suddenly sought safety of funds. As we move into Q2 of 2007 the tension between these two countervailing forces - the hunt for yield characterized by the carry trade and the demand for safety during times of risk aversion - is likely to continue to dictate the course of trade in USDJPY.

Economy Continues to Improve

In the first quarter of 2007, the Japanese economy displayed surprising strength as Industrial Production, Machinery Orders and Capacity Utilization all beat market forecasts. Indeed the GDP figures for the final quarter of 2006 printed at 4.8%, substantially better than the 3.8% expected and materially higher than the 0.8% reading from the year prior. The employment picture continued to improve as well with the unemployment rate dropping to 4.0% - the lowest level this decade while the Job - To - Applicant ratio remained comfortably above the 1.0 level at 1.05. Perhaps nothing symbolized the resurgence of the Japanese economy more than the fact that land price appreciated for the first time in 16 years, finally putting to rest the country's struggle with deflation. The lower yen continued to help exports strengthening the balance sheets of Japanese manufacturers. Toyota, for example is slated to become the largest car producer in the world overtaking GM sometime this year. The strong profit growth of the corporate sector also translated into better consumer sentiment. The Eco Watchers survey trended higher throughout the quarter nearing the key 50 boom/bust level. More importantly, overall Household spending recorded positive gains for two months in a row suggesting that the Japanese consumers are finally willing to open up their wallets. Japanese consumer spending has been notoriously slow to recover and this has been one of the principal reasons that the BOJ has remained so cautious in its stance on monetary policy. Therefore if this trend continues the news bodes well for yen bulls.

BOJ Sidelined Ahead of the Parliamentary Elections

Although the Bank of Japan (BoJ) has seen a clear improvement in the country's economic performance, the Japanese central bankers have been reluctant to implement any tightening measures. Most of the monetary policy officials from Governor Fukui to Deputy Governor Toshiro Muto have emphasized that any rate increases will be gradual. In fact, in his latest press conference Mr. Muto reiterated the idea that Japanese interest are likely to remain low for some time. One of the key statistics that has kept the central bank in check has been the relatively low level of price inflation in Japan. After turning strongly positive in the middle of last year, Tokyo CPI actually fell in the month of March while national CPI fell in the month of February (its most recently reported period), putting no pressure on the BOJ to act as signs of deflation returns. Additionally with Japanese Parliamentary elections scheduled for June, the BOJ - which has a long tradition of steering clear of the political process - is very unlikely to affect any policy changes until voting is completed. Thus, with nominal inflation essentially non-existent and the election cycle fast approaching, yen bulls cannot look to the BOJ for any help on interest rates. Therefore, if volatility in global capital markets remains muted, demand for yield will likely continue creating further demand for carry trades which could send the yen back to its 2007 lows.

Trade Friction with China Could be a Boon to Yen

The one factor that could bring volatility back in to the market and put the bid back into yen is the possibility of a trade war between the China and the US. As Q1 came to a close, US imposed tariffs on China for the first time in more than 20 years. While the amount was miniscule - tariffs on $81 million of paper products - the markets reacted violently, selling USDJPY more than 100 points in a less than an hour. As we pointed out at the time, “The impact of tariffs on glossy paper imports is small…but the reaction in both the stock and currency markets today reflects the belief that this announcement could set a precedent towards more sanctions in the future. China may decide to retaliate by diversifying some of their big war chest of foreign exchange reserves away from the US dollar. The biggest beneficiaries would be currencies such as the Japanese Yen...” The yen would benefit from such a scenario in several ways. First by having Japanese products become more competitive against their Chinese counterparts, secondly as a possible new source of investment for Chinese FX reserves and finally perhaps most importantly as a safe haven destination as many of the carry trades are quickly liquidated.

Currency markets despise trade tariffs which may lead to retaliatory measures by the counterparties and deteriorate into a full scale trade war. The US Commerce Department may have thought it was only reacting to unfair paper subsidies by the Chinese but the markets instantly thought Smoot- Hawley the notorious trade tarries of the 1920's which many analysts blame for exacerbating the Great Depression of the 1930's. For the time being the tariff issue appears to be an isolated incident but should the US Congress decide to target other, far more valuable trade sectors, global capital markets are likely to react quite negatively, creating massive volatility which in turn will benefit yen longs.

Trade Problems with Europe and EURJPY

While yen's weakness against the greenback has gone relatively unnoticed as policy makers focused their attention on the Chinese Yuan, its weakness against the euro has clearly hit a sore spot in Euro-zone. During Q1 of 2007, the EUR/JPY cross reached an all time high of 159.62 as endless waves of carry trades were put on by speculators betting on the further widening of interest rate spreads between the two currencies. Presently the European economy is enjoying a renaissance fueled by massive demand for machinery exports by China. However, even in the current favorable environment, executives of European car manufacturers have expressed concern. They complain that Japanese car manufacturers enjoy more than a $3,000 cost advantage over their European peers. Should the rise in EURJPY continue unabated, other industry spokesmen are likely to chime in with criticisms' of their own. If European growth - which has been driven almost exclusively by exports - begins to suddenly slow, Euro-zone policy makers will feel intense pressure to address this issue immediately. The situation may be further complicated by the upcoming French election in which the highly nationalistic Nicolas Sarkozy currently holds the lead. Should Mr. Sarkozy win the Presidency, France could become a vocal advocate for a lower euro against both the dollar and the yen. In short, as the second half of the year progresses, if the yen remains at persistently low levels against its G-3 partners, its exchange status may come under attack from political interests in both in Europe and US, which may force a concerted effort by the G-7 community to revalue the unit higher.

Conclusion

With the BOJ sidelined by the upcoming Japanese parliamentary elections this summer, yen longs will see no help from the monetary authorities as rates are expected to remain at 50bp for the foreseeable future. Japan's ultra low short term rates - the lowest in the G-7 universe - will continue to weigh on the currency making it vulnerable to the carry trade. The unit could see even more weakness in Q2 especially if the central banks of high yield currencies such as the British pound, the Australian dollar and the New Zealand dollar continue to push rates higher, expanding the interest rate differential. On the other hand, any increase in volatility in global capital markets could prove beneficial to the yen as the carry trade will be quickly unwound in a flight-to-safety reaction. Thus in Q2 of 2007 trading in USDJPY is likely to be dominated by the two contrasting themes of risk aversion versus the. carry trade. If the yen should weaken too much, especially against the euro, politicians may choose to intervene into the currency markets especially if the impact of the low yen exchange rates begins to affect Euro-zone export demand. That dynamic may become much more pronounced if Nicolas Sarkozy wins the French Presidential election in France in May. Meanwhile, the Japanese economy should continue to expand at a healthy rate, boosted by solid growth in the corporate sector and nascent revival of consumer demand. If consumer spending continues to pick up pace, the BOJ will soon have the leeway to implement a much more hawkish monetary regime once the elections have passed, which should provide underlying support for the yen in the long run.

Technical USD/JPY Outlook

Our line in the sand (what has distinguished bullish and bearish) has been the 8 year, 8 month trendline drawn off of the August 1998, February 2002 and December 2005 highs. The USD/JPY broke above this line in December and rallied to 122.17 before the violent sell off to 115.14 and a brief visit below the long term trendline. The recent recovery from 115.14 has brought the USDJPY comfortably above the trendline and returned the longer term bullish bias to the forefront. We still maintain that a C wave began at the May 2006 low of 108.98. This C wave is the final leg of the A-B-C correction that began after the 5 wave decline from 135.13 to 101.67 and would equal wave A (in terms of price distance) at 128.70. A rally through 122.17 increases confidence in this count. The other possibility is that the C wave ended at 122.17. Coming under the confluence of the December 2006 low / potential trendline support drawn off of the January 2005 and May 2006 lows at 114.43 makes a strong case that wave C is complete at 122.17 and that the long term downtrend has resumed.

DailyFX

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