Yen's Long-Term Outlook Deteriorates Rapidly. By Nicholas Hastings

The yen may yet have more upside potential, especially if the recent rise in risk appetite abates.

But, the currency's longer term prospects are deteriorating rapidly, especially as Japanese investors show more interest in putting their money abroad.

For now, currency flows are still dominated by optimism over second quarter earnings as well as hopes that the global recovery will continue. This is keeping the yen within a narrow range either side of Y95 to the dollar.

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If anything, upward pressure on the Japanese currency could well rise in the near term both because of a likely rebound in risk aversion as well as because of speculation over the policies that a new Japanese government might bring.

As far as risk is concerned, there are already signs that the best of the earnings season is over and the market will now focus more on the failure of the global economy not to show a more robust rebound from recession.

If that is the case, the yen will remain attractive as a safe haven currency at least for the time being.

Investors are also likely to look favorably on the currency while the market waits for clarification over the currency policies of the Democratic Party of Japan, or DPJ.

The opposition party is widely expected to sweep the ruling Liberal Democratic Party from power for the first time since 1955 in elections on August 30.

Tsutomu Okubo and Madaharu Nakagawa, the two front runners for the finance minister's job, have both expressed caution about using intervention to keep the yen competitive except in extreme circumstances.

However, Nakagawa has also expressed concern over the size of Japan's reserves, which have now climbed to nearly $1 trillion. He suggested that these should be down closer to $230 billion - the equivalent of three to four months of imports.

Simon Derrick, senior currency strategist at Bank of New York Mellon warned that any move to reduce Japan's reserves by so much would doubtless takes its toll.

"Irrespective of how long a period this took place over, it is difficult to see this acting as anything other than a significant drag on dollar/yen," Derrick said.

Nonetheless, there are other factors stacking up to push the yen the other way once the elections are over and DPJ's policy is clearer.

The most important of these is probably the Japanese investor. Investor confidence is returning and the appetite for overseas assets is rising, especially given that Japanese stocks of have generally underperformed equities elsewhere.

To feed this demand, foreign denominated-instruments designed for the Japanese investors have been rising sharply and looks set to continue. Between now and the end of the month the equivalent of another Y1.2 trillion of these bonds are scheduled to be issued.

Meanwhile, retail investors, who previously had been slow to move out the yen, have been building up yen short positions in the last few weeks - taking them up to levels last seen in September last year.

Underlying current account flows are also showing little signs of turning in the yen's favor. Data this week have shown the country's current account surplus recovering much more slowly than anticipated with exports still down a massive 36% from a year ago.

"That does not point towards a higher direct demand for yen and at the same time it creates doubts about the medium to long term attractiveness of investing in Japan," the currency strategy team at Commerzbank pointed out.

Early Friday in Europe, a decline in risk appetite was playing into the yen's hands, pushing it higher across the board.

Although Japanese equities were higher, sentiment was damaged by disappointing earnings news from Microsoft and Amazon after the close of Wall Street.

By 0645 GMT, the dollar had fallen to Y94.73 from Y95.10 late on Thursday in New York, according to EBS.

The euro was down at $1.4193 from $1.4203 and to Y134.47 from Y135.07.