Where's the yen going? Look to the Fed for answers
This year's sharp fall in the yen may have been driven by aggressive monetary stimulus in Japan, but whether that trend continues is largely dependent on the U.S. monetary policy outlook, analysts say.
The yen stood at about 99.60 per dollar on Friday, nursing losses a day after sliding about 1.7 percent as better-than-expected U.S. economic data boosted the dollar against major currencies. In fact, the dollar notched up its biggest one-day percentage gain against the yen in about four months.
"Any additional strength we see in dollar/yen will come from: a) U.S. data and b) expectations for tapering (from the U.S. Federal Reserve)," Kathy Lien, managing director for foreign-exchange strategy at BK Asset Management, told CNBC Asia's "Squawk Box."
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Many analysts expect the Fed to start unwinding its asset-purchase program in September and Lien said she expected the U.S. central bank to start sending a strong message, with dollar/yen traders likely to take their cue from rising Treasury yields.
"I don't think the [dollar] bull market has ever really gone anywhere," Ilya Spivak, currency strategist at FXCM, told CNBC. "The Fed has moderated the initial very volatile, violent reaction after the June Fed [meeting to expectations of tapering], and so we're likely to see the dollar advance in a more measured way, but the trend still very much favors the upside."
Data on Thursday showed U.S. jobless claims fell to a 5-1/2 year low last week, while growth in manufacturing activity climbed to a two-year high in July. This boosted the dollar and pushed Treasury yields higher on speculation that strong economic numbers could encourage the Fed to take back its monetary stimulus sooner rather than later.
Friday's closely-anticipated U.S. jobs report could also be key to shaping expectations for Fed tapering.
(Read More: Jobs data should show pickup in manufacturing)
Ten-year Treasury yields rose to about 2.71 percent on Thursday – within sight of an almost two-year high set in early July.
"You have to keep an eye on the bond market, with yields about to break a long-term down trend," said Chris Weston, chief market strategist at trading firm IG.
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Analysts say the rise in bond yields, linked to Fed tapering expectations, is likely to encourage Japanese investors to park their cash in U.S. bonds, driving the yen much lower against the dollar.
Japanese investors bought a net 233.2 billion yen ($2.37 billion) of foreign bonds in the week to July 27, down from 601.4 billion yen purchased in the previous week. Still, the net-buying of foreign bonds has lasted for four weeks, the longest buying spree since last November.
"If you think about what is driving flow around the world, it is the demand for yield. And we're just beginning to see Japanese investors shift their funds and move them abroad," said Lien at BK Asset Management. "As U.S. yields start to increase, it is going to become much more attractive for Japanese investors."
The yen is down about 15 percent against the dollar this year and many currency strategists see it weakening to 110 per dollar by year-end.
"If the game plan does play out as expected and the Fed does taper [in September], I think we'll certainly see dollar/yen above 100; maybe even above 101," Lien said.
— By CNBC.com's Dhara Ranasinghe; follow her onTwitter @DharaCNBC