Is dollar-yen on the verge of a breakout?

Japanese yen and U.S. dollar notes
Yuriko Nakao | Bloomberg | Getty Images

The popular dollar-yen trade, which has fallen out of favor in the recent months, is coming back in vogue, say strategists, driven by the increasingly divergent performance of the U.S. and Japan economies.

The greenback surged to a four-month high of 103.15 yen on Wednesday amid signs of a resurgence in the U.S. economy, before settling around 102.79 on Thursday.

"Dollar-yen looks to be on the verge of a breakout," Emma Lawson, senior currency strategist at National Australia Bank told CNBC on Thursday. She expects the pair to end the year at 108.

After a breath-taking 21 percent rally in 2013, currency pair has struggled this year, falling 2.3 percent year-to-date, as the yen benefited from safe-haven flows fueled by geopolitical uncertainty.

Lawson expects the dollar will continue to strengthen on signs of an accelerating U.S. recovery, while the yen will weaken as deteriorating economic data undermines confidence in Abenomics, or Prime Minister Shinzo Abe's radical economic revival program, raising the prospect of further easing by the Bank of Japan.

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Economic data suggest Japan's economy has taken a turn for the worse following the April consumption tax hike, raising questions about the strength of the recovery. Industrial production, for example, fell 3.7 percent in the second quarter over the previous three-month period, marking the first decline in six quarters.

By contrast, the world's largest economy rebounded strongly in the second quarter, increasing speculation of a sooner-rather-than-later rate hike, which would be dollar positive.

"I think dollar-yen is going to be an increasingly popular trade based on monetary policy trajectory [of the U.S. and Japan]," said Sean Callow, senior foreign exchange strategist at Westpac.

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He expects the dollar-yen pair to trade around the 105 level over the next 1-2 months.

With U.S. bond yields beginning to rise as the Fed moves closer to its first rate hike, Callow says "Japanese investors are likely to find U.S. Treasurys far more attractive in coming months, leading to increased outflows from Japan."

Santelli: Dollar/yen gone 'comatose'
Santelli: Dollar/yen gone 'comatose'

How fast dollar-yen rallies would depend on how fast U.S. yields rise, Callow added.

The yield on the ten-year Treasury note rose to 2.556 percent on Wednesday, its highest level in over two weeks. This compares with 0.54 percent for the comparative Japanese government bond.

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Greg Gibbs, head of Asia Pacific markets strategy at RBS who is bullish on the U.S. currency, says betting on a rise in the dollar-yen pair is his preferred trade.

"It appears to us that the USD/JPY is ripe for a move up in light of the substantial rise in the USD/JPY yield advantage over the past month," he wrote in a note on Tuesday.