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The Federal Reserve put the brakes on an explosive rally in the yen with an emergency cut on Friday in the discount rate, charged on direct Fed loans to banks, but the uptrend could resume next week if the central bank's action fails to put a floor under stock prices.
The yen posted its biggest gain against the dollar in around 20 months this week as growing signs of distress from the US subprime mortgage market prompted heavy selling of risky assets like stocks and high-yielding currencies.
Since the purchase of many of these assets has been funded by borrowing at the lowest interest rates in the industrialised world through the yen, the Japanese currency has rallied sharply as these trades are reversed.
The Fed's discount rate move restored some calm to financial markets. The million dollar question for traders next week will be whether this policy shift, and extra liquidity provided by other central banks, will be enough to stamp out panic in global markets.
"There is a lot of uncertainty over whether the central banks' actions will be enough in calming financial markets," said Nick Bennenbroek, head of currency strategy at Wells Fargo Bank in New York. "The big focus is going to be on the yen."
Further declines next week in stock prices, which recovered on Friday after a six-session slide, would likely be taken as a cue to resume buying the yen and dumping high-yielding currencies such as the Australian dollar, traders said. The yen's sharp rally this week has complicated the task facing the Bank of Japan next week, which is to decide on interest rates on Thursday.
Just weeks ago markets were widely expecting a quarter-percentage-point rate rise, to 0.75 percent, but financial markets are now pricing in less than a one in 10 chance that the BoJ will tighten credit. Japan's Kyodo news agency reported on Friday that the BOJ was likely to hold off raising rates.
Analysts said the dollar's losses against the yen would likely accelerate if it broke below Friday's low of 111.60 yen, which would open the way for a run at the May 2006 low of just below 109 yen.
Further gains in the yen could snowball quickly, since Japanese retail traders, a growing force in foreign exchange markets, are likely to face margin calls on their purchases of foreign currencies, analysts at J.P. Morgan say.
Although the United States has been at the heart of the global credit crunch, the greenback has been resilient, as US investors have reduced their exposure to risky trades overseas, bringing dollars back home and supporting the currency. The dollar rose around 0.7 percent against a basket of six major currencies this week.
Richmond Fed President Jeffrey Lacker is due to give a speech on the US economic outlook on Tuesday, which will be closely scrutinised for any signs that the Fed is looking to cut interest rates in September.
The Fed on Friday said that financial market conditions had deteriorated and the risks to growth had increased "appreciably." Interest rate futures are fully pricing in a quarter-point rate cut in September and a good chance that the Fed may even cut interest rates by a half percentage point.
Rising worries that the fallout from turbulent financial markets will spill over into broader weakness in the global economy are likely to keep investors wary of wading back into carry trades, analysts say. "We think the chances that there will be a sharp recovery of carry trades are very low," strategists at Barclays wrote in a note to clients. They added that they expect the dollar to resume its decline against the euro in coming weeks.
Two of the most popular "carry" currencies, the Australian and New Zealand dollars, headed the losers board this week, falling 6 percent and 7 percent respectively against the US dollar, with the kiwi on track for its biggest weekly fall in two decades.

Copyright Reuters, 2007

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