Forex

In the first quarter of 2008, the Japanese yen rocketed higher against the greenback to nearly hit 13-year highs. In doing so, the USD/JPY pair dropped below the psychologically critical 100 barrier to a low of 95.71 without even a hint of forex intervention by the Bank of Japan. Yen strength, however, was driven strictly by risk aversion dynamics rather than by any improvement in Japan’s economic fundamentals. In fact, if anything, Japan’s economy deteriorated materially as the quarter progressed, adding to evidence suggesting that a global slowdown is in the works. However, a jump in energy and food costs have finally started to spur price pressures in the economy, putting any notion of a Bank of Japan rate cut on hold. Nevertheless, with the source of the inflation strains due purely to volatile commodity price gains, rather than a broad increase in domestic demand, any significant pullback in oil and food costs may give the Bank of Japan the green light to reduce rates.

This has carried little weight with traders though, as they ignored the economic news from the land of the rising sun and focused strictly on risk aversion/risk assumption dynamics. Thus, as the wrath of the credit crunch spread through the global financial markets, with most major banks writing off billions of dollars in losses, USD/JPY declined on risk aversion flow. Looking forward to the second quarter of 2008, the pair is likely to follow a similar path, as the relentless lowering of U.S. interest rates by the Federal Reserve has removed most of the luster from the USD/JPY carry trade. Furthermore, the credit crunch is far from over, and its effects continue to ripple throughout the system, which creates significant downside potential for the equity markets and other "risky" assets.