Yen Weakness Far From Over

NEW YORK (TheStreet) -- In early April, I made the case for prolonged weakness for assets denominated in Japanese yen. This forecast proved largely accurate, as the CurrencyShares Japanese Yen Trust ETF (FXY) is 14% lower on the year; and the yen itself is the second-worst performing developed-market currency relative to the U.S. dollar.

To some, these declines might suggest renewed opportunities to buy. But when we consider the policy outlook at the Bank of Japan, and potential cutbacks in monetary stimulus from the Federal Reserve, there is little reason to believe this downtrend has reached a true bottom.

To the contrary, the yen remains a sell, even at these weaker levels. Major divergences in central bank policy favor the U.S. dollar over its Japanese counterpart, and these are trends that should continue well into 2014. In Japan, the intention has been to ramp up bond-purchasing programs as a means to normalize consumer inflation levels.

The Bank of Japan's central aim is to achieve inflation rates of 2% in the next two years and reverse decades of stagnant growth. Stimulus plans in Japan make up a larger percentage of GDP than the quantitative easing programs designed by the Fed, and this can only weaken the yen as long as policymakers remain committed to this course of action.

Diverging Policy Favors Dollar

Diverging policy in the U.S. and Japan has created bond-yield differentials in 10-year government debt that is now at multi-year highs above 2.2%. Confirmation that the Fed is truly ready to reduce monthly asset purchases and allow the U.S. economy to start working on its own merits will only propel these trends, and this could start as early as next week. Currently, markets are expecting the Fed to reduce monthly stimulus injections by $10 billion, so any number greater than that will push the U.S. dollar to new highs for the year.

Looking ahead, the fate of the yen rests on Prime Minister Abe's level of commitment in achieving official inflation goals and weakening the currency to support export companies. Early indicators will be seen in decisions to raise the national sales tax to 8% and measures to cut levies in corporate income. Some of these decisions could be finalized as early as next month.

What investors with currency exposure should be looking for is a willingness to implement more aggressive policy measures, as this will imply Japan is ready to use all available tools to make real changes in long-established trends.

Aggressive stimulus moves carry associated risks. But if Japan is ever going to become serious about normalizing its economy, risks will need to be taken. What we are looking at here is a country with debt-to-GDP ratios that average 220% (the highest in the world), growth rates that have held flat for nearly a quarter century and consistent vulnerability in consumer price pressures.

At this stage, there is no likely scenario that points toward strength in the Japanese currency. Any asset that has seen declines of almost 15% in the last three quarters might look attractive from a contrarian perspective. The reality is that we are still in the early stages of a multi-year downtrend.

The Japanese yen is a sell, even at its current moderately depressed levels.

FXY Chart Perspective

On the weekly charts, bear pressure in FXY has created oversold conditions that might look attractive for long entries, but the series of lower highs on the daily charts indicate further weakness. The symmetrical triangle that started in mid-May has broken to the downside and the next level of support can be found at 96.60. Bearish violations here will accelerate losses. Sell here, or wait for rallies back into 100.70.

At the time of publication the author had no position in any stock mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Cox is based in China, and has lectured at several universities there on international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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