Yen in focus as Nikkei nears 18-year high

Japan's benchmark stock index neared a four-week high Monday, bringing it within touching distance of an 18-year high, thanks to a weakened yen which has come back into focus as events in China and Greece die down.

After an extended weekend, the Nikkei 225 climbed 0.9 percent to trade at 20,841.97 Tuesday, just shy of 20,933 reached last month - its highest finish since December 1996.

Kazuhiro Nogi | AFP | Getty Images

Investors will be watching closely as earnings season kicks off in Asia later this week, with a "lack of investor interest" in the dollar against the likely to prove positive for further weakening in the Japanese currency, according to UBS.

"With China and Greece dominating the recent news flow, Japan remains off the radar of many investors," Daniel Waldman, a currency strategist at UBS, said on Tuesday.

"However, with inflation still low, the Bank of Japan's reflation efforts are likely to remain significant in the second half, further benefiting long dollar/yen, where we remain bullish and think risk-reward is strong."

The dollar touched a one-month high of 124.40 yen in Asian trade on Tuesday, as traders started adding to their dollar positions on the anticipation of a Federal Reserve rate hike, pushing the greenback higher against the Japanese currency.

But Waldman said this went beyond a dollar bull story. Indeed, he has predicted further weakness for the yen based on the market- "underpricing" Bank of Japan (BoJ) easing and continued portfolio diversification into foreign securities and other assets by Japanese investors.

The Bank of Japan (BoJ) trimmed its economic forecasts last week and now expects growth of 1.7 percent in the year to April 2016 – down from an earlier forecast of 2 percent. The central bank also downgraded its inflation forecast for the same period to 0.7 percent from 0.8 percent, while leaving left monetary policy unchanged.

Analysts at Barclays expect the Bank of Japan to hold fire on monetary policy for the foreseeable future, but are not forecasting a strong summer for Japanese stocks.

"More than the policy reaction function of the Fed and BoJ, we believe the high level of uncertainty in the economy itself will likely ensure a bull flattening or bear steepening and an inverse correlation in the performance of stocks and bonds," analysts led by Kyohei Morita at the bank said.

"As such, we believe that any summer rally is likely to prove short-lived."