Just How Low Will the Yen Go?

The Game Changer Rocking the Yen
Laara Cerman/Leigh Righton | Photolibrary | Getty Images

A sweeping victory for Japan's opposition Liberal Democratic Party (LDP) in elections over the weekend sent the safe-haven yen tumbling to a 20-month low on Monday, and strategists expect the currency to continue its slide under the leadership of Shinzo Abe, a proponent of aggressive easing.

Some analysts expect the yen to fall up to 7 percent against the U.S. dollar next year, after being in a downward trend over the past 3 months.

"The (election) result is clearly as convincing as many people had hoped it would be. From a policy perspective, the LDP is going to get its way. The pressure on the Bank of Japan (BOJ) is going to mean that we will see some meaningful policy steps," Ray Attrill, global head of currency strategy at National Australia Bank told CNBC.

Attrill expects dollar-yen to touch 85 before December 31, before falling to 90 by the end of 2013 – 7 percent lower from current levels.

(Read more: Japan's Deflation Battle – Why This Time Is Different )

Japan has struggled to stem the rise in the yen this year, as the currency has been a favored destination for safe haven flows amid uncertainties in the U.S. and euro zone.

A stronger yen has dented the competitiveness of the country's export sector, posing a threat to its fragile economy. However, LDP head Shinzo Abe's pledge to push the BOJ to aggressively ease monetary policy has seen the currency fall nearly 5 percent against the greenback in the month leading up to the December 16 election.

Abe, who is expected to be sworn in as prime minister on December 26, has threatened to revise a law guaranteeing BOJ's independence, if he cannot get the central bank to embark on bolder monetary easing, Reuters reported.

The BOJ is set to face a change of leadership next year, when the term of current governor Masaaki Shirakawa - regarded as cautious in his approach to monetary policy - expires in March. The government will appoint the new governor with the approval from both houses of parliament.

(Read more: Aggressive Easing Wrong Medicine for Japan: Roach)

Osamu Takashima, chief Japan forex strategist with Citibank expects the yen will continue to weaken in anticipation that the new BOJ governor will implement further easing, he said, forecasting the currency to fall to 85-86 early next spring.

In addition to expectations of a more accommodative monetary policy, Takashima said that the new government's ambitions to engage in an expansive fiscal stimulus program to bolster growth will also put pressure on the yen.

The LDP has promised to boost public works and talks of spending 200 trillion yen ($2.4 trillion) on projects over the next decade - about 40 percent of Japan's economic output.

Takashima said this could lead to an increase in imports in mid-2013, and a further deterioration of the trade balance, which would be negative for the currency.

External Forces

In addition to political forces weighing on the yen, Mitul Kotecha, head of global forex strategy at Credit Agricole CIB, said an additional risk for the currency stems from a rise in U.S. government bond yields.

"If U.S. bond yields moved higher compared to Japanese government bonds, that would be negative for the yen," he said.

Currently, the spread between the 2-year U.S. Treasury note and the Japanese equivalent is 13 basis points. However, if the recovery in the United States is better-than-anticipated, this would push Treasury yields higher and lead Japanese investors into the U.S. debt market in search for better value, Kotecha said.

Jonathan Cavenagh, senior forex strategist at Westpac Institutional Bank agrees that the combination of higher U.S. government bond yields, aggressive monetary easing in Japan and a further deterioration in country's current account balance, would weigh further down on the yen.

However, in the short-term, he said risks surrounding the "fiscal cliff" - a series of tax increases and spending cuts that will kick in on January 1, unless U.S. lawmakers arrive at a solution - will cap further downside in the currency as people continue to prefer the yen over the dollar. He added that investors are now taking profits on their short yen positions, which will also limit weakness in the yen.