The Yen Looks Set To Slide. By Nicholas Hastings

The yen finally looks ripe for a breakout on the downside.

After being stuck in a narrow trading range against the dollar for most of this year, the Japanese currency appears ready to succumb to a steady increase in selling pressure.

The rising risk of a credit downgrade combined with wider yield spreads in the dollar's favor means that the start of a new Japanese financial year next month could bring a sharp sell-off.

Or, as currency strategists at UniCredit SpA put it: "Any dollar/yen dips below 92-91.80 should represent an opportunity for new bargain-hunting."

See the dollar's recent rally against the yen:

Click image to enlarge

For the last few months, the yen has been largely immune to the woes of the Japanese economy, with the currency benefiting from a safe-haven role even though deflationary forces in Japan were growing.

In the last week or two, though, there has been creeping evidence that market sentiment is shifting, with yield differentials once again very much back in play.

"Although weakening somewhat in 2009, dollar/yen's strong prior relationship with the U.S./Japanese 10-year yield spread has now been firmly re-established," said Neil Mellor, a senior currency strategist with Bank of New York Mellon.

Although the U.S. Federal Reserve is not in any rush to raise its rates, an expected strong rise in U.S. non-farm payrolls on Friday will only increase speculation of a move being made before the year is out.

By contrast, the Bank of Japan is under more pressure from the government to ease its monetary policy again. If anything, these pressure are likely to grow if the latest Bank of Japan Tankan survey provides another depressing assessment of the Japanese recovery, as is expected.

If so, the yield spread between U.S. and Japanese 10-year bonds, which has already risen to about 246 basis points from 227 points over the course of this month, will only continue to widen.

At the same time, the Japanese government's failure to come to grips with its deficit problems is starting to threaten the country's credit rating, a move that will make the yen even less attractive.

Japan's debt-to-GDP ratio is expected to climb to well over 200% this year and hit nearly 250% by 2014. With little clear plan from Tokyo to curb this growth, chances are that a credit downgrade by the major rating agencies isn't far off.

Meanwhile, next month will bring the start of the new financial year and an end to the repatriation flows that have helped support the currency for the last month or two.

The rising expectations of higher rates in the U.S. are likely to accelerate outflows as more Japanese investors start to put their money abroad.

With U.S. yields on the rise and confidence in the dollar's rally growing, Japanese investors are less likely to hedge these flows than they might have before. As a result, downward pressure on the yen is likely to be even more intense.

Early Tuesday in Europe, a combination of rising stock prices, higher commodity prices and greater confidence about Greece's funding abilities all contributed to an improvement in general market sentiment that sent the yen lower.

The Japanese currency itself wasn't helped by the latest data showing that household spending fell by 0.5% in the year to February instead of rising by 1.5% as expected.

By 0745 GMT, the dollar had risen to Y92.66 from Y92.49 late on Monday in New York, according to EBS.

The euro was up at Y125.38 from Y124.65 and rose to $1.3527 from $1.3475.