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Dollar-yen slumps—Is more pain coming?

Japanese 10,000 yen banknotes and U.S. one-hundred dollar banknotes are arranged for a photograph in Tokyo, Japan.
Yuriko Nakao | Bloomberg | Getty Images
Japanese 10,000 yen banknotes and U.S. one-hundred dollar banknotes are arranged for a photograph in Tokyo, Japan.

The dollar-yen's sharp sell-off this week caught many investors off guard, but what underlies the dramatic declines and, more importantly, is there more pain in store?

"The burning question on everyone's mind today is whether dollar-yen will continue to head lower," Kathy Lien, managing director at BK Asset Management said in a research note published on Wednesday.

The yen strengthened 1.4 percent to 101.5 per dollar on Tuesday, after Bank of Japan (BOJ) chief Haruhiko Kuroda gave little hint of future easing at the conclusion of the central bank's policy meeting. It was the largest intraday decline for the dollar against the yen in 8 months.

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The dollar-yen recovered some of its losses in early Asian trading on Wednesday to trade around 101.9.

Japan's stock market sold off on Tuesday, and extended losses in early trading Wednesday, following Kuroda's dovish comments and disappointing trade data. Japan's current account balance shifted to a surplus in February for the first time in five months, but economists warned the balance would likely swing back to a deficit as exports to emerging markets remained weak, Reuters reported.

Lien said a number of other factors were behind the dollar-yen's dramatic move.

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Losses were further accelerated by Federal Open Market Committee (FOMC) official Narayana Kocherlakota's comments on Tuesday that the Federal Reserve was underperforming on both inflation and employment, Lien pointed out, suggesting a slower unwind of quantitative easing - which could further weaken the dollar, and in turn strengthen the yen.

Furthermore, the re-emergence of Ukraine tensions following reports of separatists seizing buildings and holding hostages gave investors another reason to bail out of dollar-yen.

Other analysts singled out dollar weakness as a key driver.

"The U.S. dollar has continued to lose ground in the aftermath of last week's employment report, even as U.S. 2-year yields stabilized around 40 basis points on Tuesday," said Daniel Katzive, FX strategist at BNP Paribas.

"Dollar-yen has borne the brunt of dollar weakness, consistent with analytics showing that short yen positioning was the largest short position among the G-10 currencies heading into the data," he added.

Divesh Divya, currency strategist at Standard Chartered also blamed the move on broad dollar weakness.

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"It does look like there is some downside risk at the moment," said Divya, adding that the pair should weaken to 100.8 over the next week as the dollar continues to weaken.

However, he added that in the long-term he still sees the dollar-yen rising to 110 per dollar by year end.

"We think it's going to be a mix of monetary policy divergence [driving the dollar-yen higher]. While the Fed gets closer to a rate hike, the BOJ will maintain its dovish stance and continues with its extraordinary monetary easing. Also the trade balance numbers in Japan should push dollar-yen higher," he added.

BK Asset Management's Lien also sees the dollar-yen moving lower in the next few trading sessions.

"There is a significant zone of support between 101.60 and 100.75 and we wouldn't be surprised to see the currency pair test the lower bound of this range," she added.

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Shorting the yen has been a popular trade ever since Prime Minister Shinzo Abe first launched his ambitious plan to overhaul the Japanese economy and drag it out of over a decade of deflation.

His policies, which have involved aggressive monetary easing, fiscal stimulus and economic reform, helped power the Nikkei 55 percent higher last year while the yen weakened over 21 percent against the dollar.

By CNBC's Katie Holliday. Follow her on Twitter @hollidaykatie