Euro Inches Higher While Yen Languishes

The nightmare for yen longs continued in Asian and early European trade today as the single currency posted record lows against the euro while GBP/JPY traded within 15 points of the 224.00 level.

The latest bout of selling was precipitated by the surprisingly weak Industrial Production numbers which declined -0.9% against expectations of a 0.8% increase. Clearly the record high oil prices in July tempered both external and internal demand in Japan but despite much hand wringing by yen bears IP was up a healthy 5.1% on a year over year basis indicating that the world's second largest national economy continues to steadily expand.

Nevertheless, the news all but erased any last hopes for an additional rate hike from the BOJ by year's end as traders bet that the weaker economic climate and change of political leadership in September will put a freeze on any policy initiatives.

The relentless decline in Japanese Government Bond yields over the past month has also weighed on the yen like a slab of concrete. The benchmark 10 year issue traded tonight within a few basis points of 1.60% level.

To put that number into perspective only one quarter ago most fixed income investors expected JGB yields to reach 2% or higher by this time of the year. The sharp drop in the long end the yield curve and stalemate in the short term rates have combined to create a toxic environment for any yen long positions as the currency continues to be subject to carry trade speculators who have grown ever more emboldened with each new release of weak economic news from Japan.

However, as many analysts have pointed out positioning has grown dangerously skewed in favor of yen bulls and while at present no obvious catalyst exits for yen strength the short JPY trade has become inordinately crowded and therefore quite vulnerable to a correction.

Given the typical pattern of yen trading should a new yen positive theme emerge in the markets after the Labor day holidays the speed of carry trade liquidation could be fast and furious. Therefore while present day fundamentals provide little reason for yen longs, probability cautions us against taking on new yen shorts so late into the move.

In the Euro-zone most of the data, including inflation and employment gauges printed in line with expectations suggesting that the ECB will maintain its gradualist approach of rate hikes with the next 25bp increase forecast for the October meeting.

Today's ECB rate announcement is expected to keep rates steady, but of more interest to the market will be Mr. Trichet's commentary regarding the record high rates in EUR/JPY. According to many analysts, last May ECB hesitated hiking rates at the time in part because of high EUR/JPY exchange rates. With the pair now nearly 400 points higher than in May, it will be interesting to see if Mr. Trichet voices any concern over this new development.