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Currency Forecast: USD/JPY Outlook

Dollar/Yen seems to have very much become the "new" carry trade of the year. With Japan offering zero interest, it is not surprising that it tops the list as the currency to sell for carry trades. The dollar on the other hand offered an increasingly higher interest rate throughout the course of this year, making the USDJPY pair the near perfect choice for this year's emerging carry trade. Japan 's economic performance in the first half of the year has been far from impressive. Growth has accelerated in the first quarter (remember Japan is on a different schedule from the US ), with consumer spending rebounding. However, exports have fallen, especially to China while deflation remains a major concern. Japan 's growth also seems to be closely tied to the fluctuations in oil prices since Japan imports over 90% of its oil. The country's citizens are already notorious savers and rarely spend, which means that higher energy costs will take an even bigger bite out of domestic spending. All of the economic data that we saw in the month of May showed signs of improvement, but at the same time, oil prices also trended lower for most of the month hitting a low of $46.20. Things should look very different in June, when Japan , along with the rest of the world has to deal with oil at $60 a barrel.

Bank of Japan Considers Raising Rates
Yet in the face of all this, the Bank of Japan has already begun talks of raising rates. In the past few central bank meetings, Mr. T. Fukuma has proposed to cut the reserve target range to 27-32 trillion yen, but as revealed in the minutes, he has consistently failed with only two votes supporting the proposal. In May, the statement was amended to include the possibility of the balance falling short of the target in times of "exceptionally weak" demand. This additional sentence was preserved in the June release after the target was breached twice on June 2 and 3. With the statement reappearing in the policy announcements and CPI peaking above the 0% mark, the Bank of Japan is slowly building on the notion they will be ready for positive short-term rates. In June, BoJ Deputy Governor Muto said that, "I believe chances will grow for a shift in the policy framework in fiscal 2006/07, but we are unsure whether we will actually go ahead with a change." If the Bank of Japan does begin raising rates, this could have significant ramifications for the Yen. A tremendous amount of speculators are still short yen for carry trades. A rate hike could trigger extensive profit taking, which would be bearish for USDJPY, especially if this comes at a time when the US is done raising rates.

Keep Watching Chinese Revaluation
Talk of Chinese revaluation has subsided a bit in the beginning of the summer, which has helped spur some of the USDJPY rally. However, revaluation still remains a pressing concern. China 's move towards Yuan convertibility is particularly important for Japan and USDJPY. Since the Yuan is not readily available for trading by individual speculators, many traders have opted to express their views through the Japanese yen instead. USDCNY forwards have a very close relationship with USDJPY, which substantiates the usage of USDJPY to express views on the Yuan. In fact, between January 2003 and January 2005, the correlation between 6-month USDCNY forward rates and USDJPY was over 80%. The selection of this pair as a trading alternative stems from Japan 's close ties with China . As a net exporter, Japan competes heavily with China . China 's artificial suppression of the Yuan has forced Japan to intervene aggressive to artificially depress their own currency throughout 2003 and early 2004. Although Japanese authorities have been absent from the market for the past few months, the market is still cautious as the possibility of government intervention looms, especially considering that the dollar is still hovering at 5 year lows against the yen. The undervaluation of the yuan creates a significant disadvantage for the rest of the G7. The severe negative economic consequences of the undervaluation have forced other G7 countries to pressure China to revalue their currency.

Dual Forces Keeping USDJPY Moves Limited
As a result, dual forces are keeping moves in USDJPY limited. On the upside, the threat of Chinese revaluation still remains in the mind of traders, keeping gains limited. On the downside, carry trade demand keeps USDJPY well bid. The third caveat is of course oil prices, which also has been positive for dollars and negative for yen.

Technical Outlook
The sun is setting on the Japanese yen with the Dollar breaking all of the major trends that drove the price action for a number of years. The last six month saw the yen consolidating within a trading range that the pair established following the failure to break below 101.70, a five year low. The trend has reversed and now we have USDJPY trading above 108. The last time the Japanese yen was this strong against the dollar was 1999, when the dollar bottomed out at 101.30. History is in the process of repeating itself given the cyclical nature of the markets. So far, the currency pair has made a new 2005 high and has been holding above the 108 level fairly well.

Yen fell back after establishing a new 2005 high, but the pair failed to break below the 108.00 figure. As the price action remains subdued, dollar bulls will most likely push the pair toward the 109.50 line, with the further move to the upside most likely capped by a new 2005 high. Indicators point to a weakening trend. Stochastic is dipping below the overbought line at 74.59. ATR is indicating a drop in volatility. ADX (DMI) is at 24.95, signaling a slowing trend. A break above 110 could see the pair test the 115 level, while a break back below 105 would be needed for any chance at testing the 5 year low.

Key Levels: Yen fell back after establishing a new 2005 high, but the pair failed to break below the 108.00 figure. As the price action remains subdued, dollar bulls will most likely push the pair toward the 109.50 line, with the further move to the upside most likely capped by a new 2005 high. Indicators point to a weakening trend. Enlarge Chart View
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