By DailyFX – The biggest event risk this upcoming week is the G7 Finance Ministers and Central Bankers meeting scheduled for February 9 to 10th… … in Essen, Germany.

The Japanese Yen has weakened significantly over the past year and has gone from being a thorn on
the sides of foreign central bankers to a major cause for concern. In January of
this year, the Yen hit a record low against the Euro, a 14 year low against the
British pound, and a nine year low against the Australian dollar, New Zealand dollar
and the Swiss franc. These milestones are extremely significant and illustrate the
reasons why certain policy officials are concerned. However despite the fanfare
surrounding this upcoming G7 meeting, the only ones that have been really screaming
are the Europeans, who are suffering from both reduced competitiveness as well as
decreasing Japanese demand. Whether the Europeans have enough sway to convince the
rest of the G7 to support an official criticism as opposed to a sideline discussion
of the Yens weakness still remains a question. Therefore we expect some Yen
strength ahead of the meeting as traders square their short positions before the
weekend event risk.

European Exporters are Suffering

German, French and Italian government officials have been complaining about the
unfair edge that the weak yen is providing for Japanese exporters and they have
signaled that they will push for the Yen to be brought up as a discussion point at
the upcoming meeting. The pressure from exporters is growing and will continue to
if the Yen does not stop its decline. Co-CEO of luxury maker Ermenegildo Zegna
recently said that at the current level (in the yen), it is becoming a
headache. These comments came after label competitor Bulgari stated a notable
decline in Japanese sales, a major market for luxury goods. Automobile companies
like Toyota and Honda have also benefited significantly from the weakness in the
yen. Record profits are projected thanks to increased sales in North America.
Atsushi Kawai, an automobile analyst at Mizhuo Investors Securities said that
Currency fluctuations probably boosted Toyota's operating profit by about 80
billion yen, while cost-cutting added 40 billion yen. Growth in the Japanese
automobile sector is coming at the expense of both US and European car
manufacturers.

What Have We Heard So Far?

Therefore it is no surprise that European policy officials are echoing the concern
of their biggest industries. Jean Claude Junker, the current chairman of the
Eurozones Finance Ministers warned that he wanted to say more forcefully that
Japan's current recovery should be reflected in the yen's exchange rate.
Unfortunately the US is too preoccupied with China to support that. Even though US
Treasury Secretary Paulson had previously said that he was watching the
Japanese currency very, very closely, he clarified the next day that he's
`very comfortable that the yen is set in a competitive marketplace. This
suggests that Europe will probably have to take on this fight on alone.

Japan is not in the wrong either. Growth has been lackluster at best and tepid wage
growth is crimping consumer demand. Even though deflation has been beaten, we do
not see any signs of inflation. Therefore in order to keep their growth
sustainable, the Bank of Japan had no choice but to leave interest rates unchanged
at 0.25 percent. However by doing this, they kept speculative interest in short yen
positions which drove the currency even lower.

What is at Stake?

First it is important to realize that the current G7 statement already includes
critical comments on Asian currencies, namely towards China. Back in April 2006,
the G7 finance ministers added the following comments to their communiqué:

We reaffirm that exchange rates should reflect economic fundamentals. Excess
volatility and disorderly movements in exchange rates are undesirable for economic
growth. We continue to monitor exchange markets closely and cooperate as
appropriate. Greater exchange rate flexibility is desirable in emerging economies
with large current account surpluses, especially China, for necessary adjustments to
occur.

This triggered a major sell-off in the US dollar against the Japanese Yen, Euro,
British Pound and Swiss Franc. In order for another major wave of dollar selling
and yen buying to occur, we would need to see that paragraph say China and
Japan.

Power of the G7

The reason why we have already seen liquidation in Japanese Yen shorts ahead of the
meeting is because the G7 truly has the power to trigger major market movements. In
the month following the April 2006 G7 finance ministers meeting, where the above
comment on China was added, USD/JPY dropped from 118 to a low of 109. At the same
time, the EUR/USD rallied from 1.2250 to 1.2975 while the GBP/USD increased from
1.7775 to 1.8770. The same thing happened in 2003 after the Dubai meeting and the
sheer possibility that this could happen again is enough to drive position squaring
ahead of the meeting.

Current Market Positioning

According to the Commitment of Traders report, positioning in the Japanese Yen is
currently at extreme levels. The non-commercial positioning data indicates that yen
short positions are at a record high. This suggests that further buyers are limited
and supports our thesis that at least some speculators will want to take profits.
In addition, speculators who encompass non-commercial positioning are typically
wrong at market turns while commercials are right. For the third week in a row,
commercials have been aggressively snapping up yen long positions. The last time
that commercial buying was this strong occurred in December 2005 when the USDJPY
topped out at 121.38. All of this supports some additional yen gains going into the
G7 meeting.

Trading Implications

The most important implication of the report is the possibility of more Yen buying
over the next few days. Back in May, we published a report comparing the movements
of the majors the 4 months after the 2003 meeting and the first 3 weeks after the
April meeting and as you can see in the table below, the moves were substantial.
Therefore we caution against holding any major positions going into the weekend and
the likelihood for more yen short covering before that. Should the G7 surprise
with a statement, the table below also indicates that these moves have significant
follow through.

Kindest Regards,

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com

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