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Why shorting the yen could still work

Haruhiko Kuroda, governor of the Bank of Japan, speaks at the central bank's headquarters in Tokyo, June 13, 2014.
Kiyoshi Ota | Bloomberg | Getty Images
Haruhiko Kuroda, governor of the Bank of Japan, speaks at the central bank's headquarters in Tokyo, June 13, 2014.

Janet Yellen isn't the only major central banker taking the podium this week.

Bank of Japan's Haruhiko Kuroda will also speak, as the central bank wraps up its two-day policy meeting Tuesday morning (Monday night in the U.S.)

With both central banks in the spotlight, it's time to look at the prospects for the Japanese yen.

It's stronger this year, up 3.8 percent, after declining 16 percent last year.

Shorting the yen was one of the hottest bets on Wall Street last year, with hedge fund heavyweights like Third Point's Dan Loeb and George Soros betting the currency would weaken.

That bet certainly paid off, so now where do investors stand?

Read MoreFor Asia, BOJ and China data in driver's seat

For the most part, speculators are still shorting the yen. There's a net $8 billion bearish bet on against the yen, according to the latest weekly data on speculators and large hedge funds from the Commodities Future Trading Commission.

The only currency that traders are more bearish on right now is the euro.

Why?

Many expect the Bank of Japan to ramp up its monetary stimulus, as growth slows and Prime Minister Shinzo Abe ups his battle against slow growth and persistent deflation.

Already, Kuroda is pumping 60 trillion yen ($587 billion) to 70 trillion yen into the economy each year through bond purchases or quantitative easing.

At this week's meeting, the central bank is widely expected to stay the course, refraining from new moves to easy policy.

But that doesn't mean it won't move later this year.

Read MoreJapan May orders data shocks, worries about recovery mount

"If BOJ Governor Kuroda provides a less optimistic read on the economy and acknowledges that outcomes are worse than expected, the odds of an ease go up, as well as the risk that it occurs sooner than later, so the Japanese yen weakens," said Steven Englander, chief FX strategist at Citigroup.

The government raised the national sales tax to 8 percent in April from 5 percent, and the impact has hit consumer spending and cut manufacturing. If that weakness proves more than temporary, it could trigger action from the central bank.

That's why it will be key to hear what Kuroda says about his growth forecast.

"Leading into the BoJ meeting, concerns are rising that the central bank's forecasts will be revised lower and the tone will provide a hint of dovishness," according to a note published by Camilla Sutton, chief foreign exchange strategist at ScotiaBank.

In a Bloomberg News survey of economists published this month, 32 percent predicted the Bank of Japan will expand its stimulus on Oct. 31. On the other hand, 26 percent said the central bank will not increase it at all and 18 percent forecast April 2015 or later.

Even if the Bank of Japan does not step up stimulus, strategists say, it remains firmly in easy mode, and that could still trigger a weak yen, when you compare that policy to the Federal Reserve's path.

"I think the main driver of the yen will be U.S. monetary policy, and a continued drift higher in inflation expectations in japan. Even without more action from the BOJ, real rates are going down when inflation expectations increase. I think this, combined with different signals from the Fed, probably in Q4, will see USD/JPY test highs around 105," according to Jens Nordvig, global head of foreign exchange strategy at Nomura.

The Fed is increasingly pulling back on its unprecedented stimulus (tapering), and there's a growing chorus of economists, inside and outside the Fed, talking about higher interest rates. That difference in policy stance holds the key to the yen's move.

"I still think there's some upside for U.S. dollar versus the Japanese yen, but it will really need to come from higher interest rate expectations in the U.S. and an end to the Fed balance sheet expansion," said Robert Sinche, global strategist at Pierpont Securities.

"I still think dollar-yen is heading to 105-110 trading range by later 2014, but driven by Fed policy not BOJ."

So far, low interest rates in the U.S. and a surprisingly weak GDP number in the first quarter have kept pressure on the dollar versus the yen, one of the pairs most correlated to the move in interest rates, especially at the short end of the yield curve.

But that could change as the U.S. continues to show improvement in the labor market, inflation creeps higher and consumers pick up their spending.

Read MoreAre investors losing patience with BOJ?

Bottom line, when it comes to the dollar against the yen, strategists say the stage is set for a weaker yen, but it's certainly not going to be on a one-way ticket lower, as there was last year.

—By CNBC's Sara Eisen

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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