Japanese Yen: Will Risk Flows Hold Up To A Severe Recession?

Fundamental Outlook for Japanese Yen: Neutral

- The vital, Japanese export sector is still weighing the economy down; but sentiment is still improving
- Despite the passing of so much significant event risk, sentiment has fallen back after months of rallying
- Is the USDJPY chart playing out a head and shoulders formation? The weekly technical outlook takes stock

The Japanese yen was one of the few currencies this past week to produce a consistent and aggressive move. Taking advantage of the unwinding of risky positions that were built up through most of March and April, the safe haven rallied 6.3 percent against the New Zealand dollar, 5.7 percent against the Australian currency and even managed a 3.3 percent advance against the greenback – the other safe haven currency. Looking ahead to next week, there will be two key, fundamental concerns for traders: the overall appetite for risk and the yen’s unwavering brand as the market’s harbor in uncertain seas.

The easier task is gauging the health of risk appetite. This past week, it was clear that optimism stalled. Without the threat of a major bank failure or shock to the credit market since the October market crash that followed the Lehman and AIG troubles, we have seen investors cautiously diversify away from risk-free assets like treasuries back into the more speculative asset classes like corporate bonds and equities. It is hard to miss the aggressive advance in key gauges like the Dow Jones Industrial Average and the DailyFX Carry Index . However, it is important to distinguish whether this is a rise in optimism or merely a return of investable funds to the market. In all likelihood, the bulk of this rebound can likely be attributed to capital finding its way back into the market in search of a competitive return. Investors wouldn’t attempt this if they were panicked; but if they believed the worst of the shocks are behind us, they would. However, this is different from a true rise in confidence where market participants have a major of their funds in the speculative arena and are trying to outpace the markets returns. With little hope for meaningful earnings, dividends, yields or capital returns through the rest of this year, traders will be standing with one foot out the door. All it will take is a possible financial crisis in the Euro Zone, US, UK, China or Japan and the whole world would reel in response.

While it is easy to determine the general level of sentiment in the market; it is a subtle and nuanced effort to measure an instrument’s relation to such a broad theme. Despite the significant deterioration in the Japanese economy over the past months, the yen has managed to retain its place as top refuge with few corrections. However, with each problem that arises from the Land of the Rising Sun (political, financial, economic), the less suited it seems for such a title. Indeed, we have to remember that this economy stagnated for more than a decade before this crisis as ill-conceived policy measures dampened a true recovery for the world’s second largest economy. Event risk over the coming days may feed such misgivings. Topping the list, is the preliminary revisions for the first quarter GDP readings. The initial 12.1 percent pace of contraction reported last month marked the worst slump since 1974. Should the plunge be revised down to 15.9 percent it would be the worst pace on record and likely signal a technical depression. Can an economy that is leading an economic malaise and will likely struggle to recover for years stand as a safe haven for capital? That is for the market to decide.

British Pound May Lose Ground Amidst Release of UK CPI, BOE Minutes

Fundamental Outlook for British Pound: Bearish

- UK trade deficit, jobless claims show signs of improvement
- UK industrial, manufacturing output declines start to slow
- Bank of England Quarterly Inflation Report triggers steep GBP losses amidst worsening outlook

The British pound wrapped up the past week down against the US dollar and Japanese yen, but up versus the rest of the majors. Looking to GBP/USD specifically, the pair remained contained within the same rising channel it has traded within for nearly a month, despite the bleak fundamental outlook for the UK. That said, there will be a variety of triggers for a GBP/USD breakdown next week, as inflation data and central bank-related news tends to spur volatility.

On Tuesday, the UK’s consumer price index (CPI) reading for the month of April is expected to rise 0.4 percent, the third straight increase. However, the annual rate of growth, which is more closely watched by the Bank of England, is forecasted to fall to a more than one-year low of 2.4 percent from 2.9 percent, keeping inflation within the central bank’s acceptable range of 1 percent - 3 percent, but above their 2 percent target. If CPI falls more than projected, the British pound could pull back sharply as the markets will anticipate that the BOE will expand their quantitative easing efforts even further. On the other hand, if CPI holds strong, the currency could rally in response.

On Wednesday, the minutes from the Bank of England's May 7 meeting may not be as market-moving as they've been in the past, as there has already been significant detail revealed about the mindset of the Monetary Policy Committee (MPC). Indeed, we already know that the BOE has decided to expand their quantitative easing program by 50 billion pounds to 125 billion pounds, that the drop in Q1 GDP of -1.9 percent was worse than expected, and that CPI will likely will be below the BOE’s 2 percent inflation target in the medium term. However, the growth and inflation outlook published in the BOE’s Quarterly Inflation Report suggests that the central bank may be open to expanding their quantitative easing program later on. If the minutes from the BOE’s most recent meeting reiterate this, the British pound could pull back very sharply.