Many currency traders have been trying to understand why USD/JPY has been decoupling from the equity market and the other major currencies. It has rallied on good data, but has sold off on weak reports and failed to strengthen despite earlier gains in US equities this month. In fact, it appears that currency traders want to do nothing but sell USD/JPY, leading many people to wonder why.

There are a multitude of reasons why currency traders want to bail out of US dollars, and those reasons were compounded by recent fears that the US could lose its prized AAA rating. In addition to fear of US debt, here are some of the reasons why the dollar has been falling, particularly against the Japanese yen.

Fear of US Debt and More Cries from China

If the UK had the outlook for its credit rating cut from stable to negative, then the US deserves to as well. In a special report on Thursday, we showed a chart of the debt loads for the G20 countries and based upon the chart, which comes from the forecasts by the IMF, the U.K.’s debt as a percentage of GDP is less than that of the US, Japan, Germany, France, and Italy. Both the US and the UK are spending money left and right, and although the risk of an actual credit rating downgrade any time soon is low, it is more than likely that Standard and Poor’s is already reviewing the US’ sovereign debt rating. Whenever there is uncertainty, investors always sell first and ask questions later. If S&P cuts the US rating outlook, it would also be the perfect opportunity for China to drive the knife in deeper by reminding the markets that they are concerned about the value and safety of their US dollar investments. The risk is too large and the possibilities are too great for investors to want to hold large amounts of US dollars, particularly against the yen.

More Quantitative Easing?

Based upon the April 29th FOMC minutes, the Federal Reserve is considering increasing their asset purchases to speed the recovery. By doing so, they may need to print more money to fund their purchases. The risk of the US government actually defaulting on its debt is very, very low, but the risk of the central bank printing more money to buy more debt is high. This would devalue the dollar, which would inevitably lead to higher rates of inflation. The surge in gold prices indicates that some traders are already anticipating this, and with these risks in mind, why wouldn’t you sell dollars?

Dollar as a Funding Currency

As the most liquid and actively traded currency in the world, the drop in volatility has made the US dollar an increasingly attractive funding currency. The following chart illustrates the correlation between USD/JPY and three-month LIBOR rates. As it gets cheaper to sell dollars, more traders are doing so. Conditions are not ripe for a carry trade recovery, but the decline in volatility (see VIX chart) has some carry traders dipping their toes back into the water.

Exporter Selling—Japanese Hate Yen Strength

Japanese exporters have also been aggressively selling USD/JPY. Whenever the yen rises, companies like Honda and Toyota suffer greatly. According to the March Tankan report, Japanese exporters expect USD/JPY to be at an average exchange rate of 97.18 for the 2009 fiscal year. Since their revenue will be estimated at the level, they will be looking to hedge against any yen strength beyond 97. With revenues already under pressure, Japanese corporations will probably do all that they can to protect their meager profits. Having traded below 88 earlier this year, Japanese corporations don’t want to risk USD/JPY returning back to those levels. Their selling has played a major role in the erratic price action of USD/JPY.

Technical Break

Finally, there have been some significant technical breaks in USD/JPY. On May 12, the currency pair entered the “sell zone,” which we determine using Bollinger Bands. The next day, it broke below the neckline of the head and shoulders pattern, which coincided with the 38.2% Fibonacci retracement of the August to January selloff. USD/JPY is now trading below the 100-day SMA, and if it closes below 94.00, there will be no meaningful support in the currency pair until 90. A break above 96 would invalidate the downtrend.

By Kathy Lien, Director of Currency Research at GFTForex.com