Japan Will Have To Cap Yen Rally Soon. By Nicholas Hastings

Talk of Japanese intervention may soon turn into action.

The need to halt the yen's rise is becoming imperative as the euro plumbs new eight-and-half-year lows under Y110 and as the Japanese economy recovers very slowly.

The following graph shows the extent of the euro's fall against the yen this month:


Click Image to Enlarge


There is little to suggest that the yen's advance will stop on its own.

On the contrary, events this week have not only confirmed that the euro is probably now set for a longer term downtrend, with little chance of any near-term relief while the yen continues to be seen as a safe haven by international investors.

Concern over the euro zone banking system, reflected in a sharp rise in bank funding costs, has replaced earlier worries about contagion from the Greek debt crisis.

Currency markets are still being driven by fears over risk as they have been for the last few months, instead of normal interest rate considerations based on the movements in yield differentials.

The problem this is starting to pose for the Japanese economy will be driven home later his week when data is likely to show that disinflation has grown worse, that retail sales have fallen and that the recovery is even more dependent on the export sector.

The yen's strength against the euro is particularly damaging as Japanese exports to the euro zone become more expensive while their exports to other markets compete with cheaper euro zone exports.

There is also the problem of the yuan.

The more the euro falls against the Chinese currency, the less the pressure on Beijing to revalue and the longer Tokyo will have to wait for improved competitiveness against Chinese exports.

The problem for the Japanese authorities is that even though the country's fiscal position is the worst among G7 countries and its deficit is only likely to get bigger, the yen is unlikely to suffer. As domestic savers holding 93% of Japan's government bonds, any large selloff when risk is ruling market sentiment is hardly likely.

With so little likely to halt the euro's rot, technical analysts such as Howard Friend at MIG Bank, reckon that the next target for the single currency is Y108.25 and after that, way down at Y101.25.

This outlook helps explain why Japanese banking minister Shizuka Kamei is reported to have asked the country's finance minister Naoto Kan about looking into international coordination to stabilize currencies.

Early Wednesday in Europe, the euro's bounce on the back of slightly improved market sentiment overnight was proving short-lived. The euro, which had bounced against the yen, was back down at Y111.00 by 0645 GMT, virtually unchanged from Y110.98 late Tuesday in New York, according to EBS.

Although Asian stocks were higher, with the Nikkei gaining 0.7% and the Shanghai Composite up 0.4%, the euro had also slipped back to $1.2289 from $1.2328 on continued concern over euro zone banking problems, Germany's extension of its ban on short selling and Fed Chairman Ben Bernanke's reminder that dollar swap lines put in place during the credit crunch are not permanent.

The dollar rose to Y90.28 from Y90.05.