Underlying caution over carry trades will provide further short-term yen protection.
The yen fluctuated either side of the 113.0 level against the dollar on Wednesday with a slight weakening bias in US trading while strengthening to beyond 163.0 against the Euro. There were no major changes in Asia on Thursday with the yen around 113.20 against the dollar before modest gains as underlying yen demand remained firm. The Chinese interest rate increase will help underpin the yen in the very short term.
As expected, the Bank of Japan held interest rates at 0.50% following the latest policy meeting. Mizuno, who has consistently voted for a rate increase over the past few meetings, joined the majority in voting for rates to be left unchanged and markets will not be expecting a near-term increase in rates which will maintain Japanese currency vulnerability on yield grounds.
The yen will still gain support on fears that sub-prime losses were spreading, especially after the ratings downgrade of bond insurers MBIA and Ambac Financial. These downgrades will increase fears over the impact of the credit crunch and a further series of downgrades. In this environment, there is an increased risk of a forced unwinding of leveraged positions which could strengthen the yen sharply, especially with tightening liquidity conditions.