Japanese Yen to Decline If Risk Recovery Lifts Carry Trades

- U.S. dollar selling intensifies against Japanese yen.
- Speculative sentiment points to continued yen gains.
- Yen futures positioning reverses from bearish extreme.

The Japanese yen may temporarily decline after five consecutive weeks of gains as an upward correction in risky assets boosts carry trades at the expense of the stand-by funding currency.

The MSCI World Stock Index, a gauge tracking global equities' performance, has capped a fourth consecutive week of losses - the first such losing streak since July 2009. While this would suggest that risk aversion is still in play, a sudden reversal on US exchanges late into Friday's session suggests an upward correction may be ahead. Indeed, the last two hours of trading saw the S&P 500 recovery from a 1.8% selloff and narrowly finish the day in positive territory.

Rumors that the European Union will announce a bail-out of debt-stricken Greece and Spain this weekend was cited as the reason for the sudden about-face in U.S. trading. This seems plausible: from its inception, the European Union was always an arrangement of geopolitical expediency rather than sound economics. In fact, a plethora of economists have produced evidence over the years to show that even the original six western European nations that formed the common market did not have economies that were convergent enough to be unified into a single unit, which surely means the much shakier southern European ones were not even close. This means that, tough talk about fiscal discipline notwithstanding, the European Union does not see it as politically acceptable to allow an economic failure that would compromise the structural integrity of the regional bloc. On balance, this means a bail-out is probable at some point. The short-term implications of such a rescue would likely give a short boost to investor confidence, allowing for an upward correction in risky assets.

Carry trades - a good bit of which are funded with capital borrowed cheaply in Yen - followed the spectrum of risky assets lower over recent weeks. Indeed, a Deutsche Bank index tracking G10 FX carry trade returns has had a near-term correlation reading of well over 0.90 with the MSCI World Stock Index. As traders moved capital out of carry trades along with bets on other risky assets, they bought back yen to repay the borrowed capital used to establish the positions, sending the Japanese unit broadly higher. This dynamic may be thrown into reverse if risk appetite is to correct higher on an E.U. bailout, sending the Yen lower in the near-term.
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