By DailyFX – Japanese markets have been volatile in recent trade, as quickly shifting speculation over tomorrows BoJ rate decision has left few assets untouched…. …

This has been most clearly visible in Japanese Government Bonds, with yields on the 10-year note
trading within a wide range since early December. Hesitation over the future of
interest rates has likewise had a very noticeable impact on the Japanese currency,
with the USDJPY moving over 300 basis points in a matter of two weeks. Despite calls
for a continued Yen rally, speculators quickly sold off the Asian currency on
falling probabilities of an interest rate hike through December. Frustrated JPY
bulls will depend on the upcoming BoJ announcement, with the future of the currency
strength hanging in the balance. One can find few economists or fundamental
strategists to claim that the Yen is fairly valued against major currencies, but the
clear deciding factor remains: will the BoJ move to tighten through the coming
months? Synthetic forward rates have priced in a cumulative 75 basis points of hikes
through year-end 2007, but such an outlook may change if the central bank is
considerably more hawkish or dovish than bulls or bears expect.

Bonds – Japanese 10-Year Government Bonds

JGB yields have seesawed in the past two weeks of trading, as a peak of 1.715
percent on the 10-year issue proving unsustainable. A sharp gain in prices led the
same rate to drop to 1.610 percent through the same period, with rumors of no
impending BoJ hike sparking sharp moves in Japanese fixed income markets.
Regardless, a later turn in sentiment was enough to push the 10-year to just under
1.7 percent through the recent close. Bears scaled back expectations of steady
interest rates through the coming months, instead allowing for a greater possibility
of monetary policy tightening through coming meetings. This has not translated into
expectations of a rate hike through the upcoming meeting, however, with overnight
swap rates pricing in only a 12 percent chance of a 25 basis point rate hike.
Clearly, markets will pay very close attention to the commentary to follow. Given
that the BoJ is very concise in its commentary, any subtle shift in dovish or
hawkish biases could spark large moves in bonds and other asset classes.

FX – USD/JPY

The carry trade has long been a burden for the Japanese yen. With the lowest
lending rate among the industrialized economies, the Japanese yen has suffered as
the short side to many long-term traders looking to collect the steady interest rate
differential. However, a recent topping in the one of the yens most liquid
pairings, the USDJPY, could suggest the markets are pricing in rate hikes relatively
soon. In mid-October, the pair ended its rally short of the previous high in
December of 2005. Furthermore, Bank of Japan officials have repeatedly expressed
the need for interest rate normalization and were not shy in suggesting it would
come sooner rather than later. On the other hand, the recent slate of data releases
and heavy handed government officials make a convincing barrier to the eventual
move. In the past few weeks, core inflation for the nation edged back to a modest
0.1 percent pace of annual expansion, the Eco Watchers current and outlook reads
retreated to net pessimism, and labor cash earnings passed unchanged. If the BoJ
announces a rate hike, it would still be a surprise for the market despite more
favorable levels of speculation. This surprise would in turn suggest there is
building momentum in policy to bring overnight lending rates to levels considered
more consistent with its global counterparts. If this sentiment catches on in the
currency market, a more substantial unwinding of short-yen carry trades could evolve
than was seen in July when the BoJ picked the rate up to 0.25 percent. Unless this
sentiment spreads though, the powerful draw of the lucrative carry trade will remain
a dominant force and pairs like USDJPY, EURJPY and GBPJPY will continue to push
ahead.

Equities – Nikkei 225 Index

Though the international spot light has been turned on a possible second lift in
Japans overnight lending rates, local equity markets have paid little heed to the
soothsayers. Investors have continually bid the benchmark Nikkei 225 Index since
last month. From November 27th, the index has rallied 8.6 percent with nary a
break. While this may be construed as somewhat risky in the face of an oncoming
policy decision, the factors surrounding the release have supported a more probable
pass. In the past weeks, few of the necessary economic releases have pressed the
need for the removal of monetary stimulus. Inflation reads have stagnated, earnings
reports have passed unchanged and consumers spending habits have allowed little
room for firms to raise prices. What could also be inferred from this healthy rally
despite heated speculation of a potential rate hike is that businesses and investors
are prepared to take on the burden of another rate hike. To properly measure the
equity markets tolerance for higher rates, a reference to Julys 0.25 percent
hike from nearly zero percent overnight cash rates reveals that the Nikkei quickly
recovered after a short-lived sell off. From that point, the market has steadily
risen to seven-month highs. Should the BoJ deliver a surprise to government
officials and the international capital markets by lifting the short-term rate to
0.50 percent though, a correction would most likely occur. It will be the reaction
from this point that really determines the health of the Japanese business
community. If stocks weather the increase and are eventually put on the path to new
relative highs, it would suggest firms are ready to wave in normalized lending
rates. On the other hand, todays relatively unchanged price action shows
hesitation. Therefore, should a pass come out of the two-day meeting, a relief
rally would be expected as long as international stock markets continue to advance
in tandem.

Regards,

John Kicklighter
Forex Capital Markets
32 Old Slip, 10th Fl
New York, NY 10005
Email: jkicklighter@dailyfx.com

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