Japan is expected to step into the currency markets to curb the yen's surge to record highs against the dollar and has a better chance of success if it wins the blessing of the Group of Seven industrial nations.
G7 finance chiefs will hold a teleconference at 2200 GMT on Thursday and the foreign exchanges are abuzz with speculation that the meeting will address a sharp overnight surge in the yen that Japan has blamed on speculators.
Japanese Finance Minister Yoshihiko Noda declined to comment on the possibility of currency intervention but said authorities were closely monitoring the market moves [ID:nL3E7EH0CH].
Still, Japan's insistence that the surge in the yen seen since last week's earthquake in Japan is driven by speculation -- and the dearth of evidence to show Japanese capital repatriation is behind the move -- is prompting traders to brace themselves for sharper rhetoric and intervention.
If Noda is to be believed, i.e. that sharp yen gains are due to speculators rather than repatriation flows, then markets can be categorized as near disorderly, said Tom Levinson, currency strategist at ING.
If so, coordinated G7 intervention to sell yen is very likely -- this has not occurred since G7 bought euros in 2000. At this time, there is unlikely to be significant G7 opposition to such action, despite Noda's claim that he only wants psychological support from the G7.
The dollar slid to a record low of 76.25 yen in early Asian trade on Thursday, accumulating losses of 8.4 percent since the earthquake.
While it recovered to 78.76 yen, investors like model funds are adding to long yen positions, making it possible that the yen will set new record highs in the coming days or weeks.
Traders said the speed of the yen's move -- the dollar shed more than three yen in some 20 minutes -- triggered margin calls for Japanese retail investors who had funded trades with cheaply-borrowed yen.
Moreover the sharp volatility seen in the currency markets was not mirrored in bond or stock markets, giving ammunition to those who are arguing that the yen moves are disorderly.
Disorderly moves are frowned upon by G7 policymakers, whose finance chiefs regularly point out that they are prepared to act against them.
Moreover, a stronger yen risks compounding Japan's economic troubles as it struggles to contain a worsening nuclear crisis.
This meant it was only a matter of time before Japan resumed intervention of the sort last seen in September, analysts said.
Japan launched a record one-day, $26 billion bout of dollar-buying intervention in September when a stronger currency was undermining the stock market and threatening to worsen deflation. The dollar rose from around 83 yen to nearly 86 yen.
At that time, Japan intervened alone as the United States was grappling with prospects of a double-dip recession and paving the way for more quantitative easing while Europe was tackling the sovereign debt crisis. In fact, European policymakers were opposed to any joint intervention.
This time around, there seems near unanimity that there has been excess volatility in the past few days.
The focus for the yen over the next 48 hours is what the G7 will do, said Kit Juckes, currency strategist at Societe Generale.
The right outcome for Japan is not to have a strong currency, but monetary easing. It makes sense for the G7 to coordinate input for a weaker currency.
While there may be questions whether the dollar's fall from 83 yen to 80 was excessive, there is unlikely to be disagreement about the move down from 80 yen to 76 yen, analysts say.
While the dollar was falling, liquidity evaporated and offers to buy were pulled, leaving huge gaps in the charts.
This was also reflected in the derivatives market.
Implied volatility, a measure of how much the market thinks a currency will move, jumped across different time horizons. The one-month implied volatility leapt to 18.5 percent, from around 13 percent in an hour as dollar/yen slumped.
If we see further bouts of extreme volatility then the Bank of Japan would be well served to step in simply to calm nerves, Westpac analysts said.
Analysts say that in addition to selling yen in the spot market, G7 officials could establish emergency lines to provide yen liquidity like the lines that were established in 2009 and 2010 which provided dollars to banks outside the United States.
(Graphics by Scott Barber and Eric Burroughs)