Yen Back in Hot Demand; Mixed Views Re Near-Term Direction - Analysts

The Japanese yen was back in hot demand Tuesday, despite the Japanese government's downgrade of the economy, announced overnight, and despite the increased negativity of Japanese government bond yields.

In terms of direction, market players had mixed views about whether the yen would continue to strengthen into fiscal year-end March 31, or whether the recent shake-out of yen short positions had already mostly run its course.

Dollar-yen was trading around Y112.60 in afternoon action, on the low side of a Y112.43 to Y113.52 range.

Only March 2, dollar-yen was topping out at Y114.56, and the market had high hopes for a test of the psychological Y115 level if not the Feb. 10 highs near Y115.26.

However, the pair was unable to make topside progress and subsequently dollar-yen moved lower.

Earlier today, dollar-yen took out Friday's non-farm payrolls day lows near Y113.13, with scope now for a return to the March 1 lows near Y112.16.

A decisive break below Y112.00 would ring warning bells and target the 2016 twin lows of Y110.99 (Feb 11) and Y111.04 (Feb 4).

"Given likelihood for JPY buying among exporters and institutional investors to hedge ahead of the fiscal year end, rallies in USDJPY may be capped," Citi G-10 FX strategists said.

From a technical perspective, analysts were watching both sides of the recent range.

"Short-term momentum studies" are overbought currently, with scope for another "downswing within this developing consolidation phase," said JP Morgan technical analyst Niall O'Connor.

On the topside, "the key hurdle remains the Y114.88/Y115.05 resistance area", which contains the prior week's high and the 38.2% Fibonacci retracement level, he said.

"Near-term pullbacks should find support at Y112.55/Y112.00 levels, with breaks allowing for a retest, if not break of short-term range lows," O'Connor said.

There were several catalysts for the day's rally in the yen, from mixed Japanese data and a government downgrade of the economy, to weak Chinese trade data and oil prices being unable to break key resistance in the form of the 2016 high, which prompted larger profit-taking in other risk friendly trades.

"There were two reports in Japan that caught investors' attention," said analysts at Brown Brothers Harriman.

The first was that Q4 2015 GDP was revised to -1.1% at an annualized pace from -1.4%, better than MNI's median of -1.4%.

Then, "Japan reported a considerably smaller-than-expected current account surplus for January," at Y520.8 billion versus Y960.7 billion in December and estimates of Y715 billion, they said.

Along with the current account data, Japan reported portfolio flow details, showing that China was a large (about $17.4 billion) buyer of Japanese money market instruments, "the most since 2005," BBH said.

Overnight also, Japan's Cabinet Office downgraded its overall economic assessment based on the survey for the first time in 15 months.

The Watchers' unadjusted indexes for both the current climate, at 44.6 in February versus 46.6 in January and the outlook index, at 48.2 in February versus 49.5 in January, stayed below the key 50 level for the seventh straight month.

"The economy has shown weakness amid concerns that the unstable financial markets as seen in the appreciation of the yen and lower share prices will affect consumption," it said.

Looking ahead, the government said, "There are some expectations for spring sales and lower interest rates for loans, but the impact that fears about the future and developments in financial markets will have on business and household sentiment must be watched closely." See MNI Main Wire at 2:06 a.m. ET for details.

As a result of the government downgrade and Chinese trade date showing exports falling 25.4%, the biggest drop since May 2009, ten-year JGB yields fell to a record intraday low of -0.112%, before closing near -0.099%, which was a record low close.

The 30-year JGB auction earlier Tuesday saw solid demand, with the bid-to-cover ratio surging to 4.21, the highest since May 2014, from 3.04 at the previous sale and the tail narrowing sharply.

In a recent note, Morgan Stanley strategist noted, "We expect the super-long sector to lead a further flattening of the curve as domestic investors seemingly remain reluctant to accept negative yields."

Ever negative Japanese yields have not had the desired effect on the yen or Japan's stock market.

The Nikkei 225 closed down 0.76% Tuesday, on the low side of a 16,570.22 to 16,911.32 range.

Like dollar-yen which struggled last week to break higher, the Nikkei topped out March 4 at 17,042.92, unable to revisit 17,905.37, last month highs, posted Feb 1.

From the Feb. 12 trough of 14,865.77 to last week's peak, the Nikkei was up 14.7%. This compared to the 11.0% gain in the S&P 500 seen from the Feb. 11 trough of 1,810.10 to the 2,009.13 peak posted March 4.

For now, market players saw dollar-yen as holding within the rough Y111.00 to Y115.00 range seen since mid February.

"While further risk-related bouts of JPY strength cannot be ruled out, we think several factors should support the uptrend in USD/JPY reasserting itself going forward," said Adam Cole, head of G10 currency strategy at RBC Capital Markets.

"Risk appetite already appears to be stabilizing, if not improving; The rates markets have started to re-price Fed rate hikes and we think this can continue until at least two hikes are fully priced," he said.

Nevertheless, a larger decline in USDJPY "would materially raise the risk of intervention," Cole said.

In the bigger picture, RBCCM maintained their stance that ultimately the yen should weaken versus the dollar.

"In our view, the capital outflows that drove USD/JPY to the 2015 high around Y126 are ongoing and, were it not for several bouts of severe risk aversion, the uptrend would have continued," Cole said.

In terms of flows, "the GPIF reallocation into overseas assets, on our arithmetic, has at least another six months to run and other public sector outflows will compound the JPY selling that results," he said.

RBCCM continued to look for private sector investors to begin selling JPY ("via lower hedge ratios") as U.S. Treasury yields rise further, Cole said.

In terms of 2016, RBCCM has a dollar-yen forecast of Y117 for Q1, Y120 for Q2, Y124 for Q3 and Y128 for Q4.