A surprise announcement by North Korea that the country has just conducted its third underground nuclear test, put a crimp in the USD/JPY rally as risk aversion sentiment suddenly settled on the currency market. Earlier at the close of North American session, USD/JPY exploded to fresh three year highs hitting 94.45 on comments from US Treasury that it supported Japanese efforts to reflate it economy.

The statement by U.S. Treasury Undersecretary for International Affairs Lael Brainard said the United States supports Japanese efforts to end deflation and re-invigorate growth. This was a significant development that indicated that US is willing to tolerate a much weaker yen in order to help Japan revive its economy and help stimulate global growth.

The tacit approval by US officials may have been a geo-political as well as an economic action. Japan, which is seen as US’s closest ally in Asia needs to act as a counterbalance to China which is increasingly viewed by US authorities not only as major trading partner but as the primary military foe in the 21st century. As Japan’s export driven economy has been hobbled by the dual forces of strong yen and escalating conflicts with China, its ability to challenge and check China has been weakened materially. Therefore, the statements by US Treasury may be part of a longer term plan by US to revive Japanese economy and as such suggest that USD/JPY could rise to 100.00 over the next several months without much US opposition.

In the meantime however, the nuclear test by North Koreans clearly took the markets by surprise and took the wind out of the sails of the USD/JPY rally. According to the NY Times, “ The test set off a scramble among Washington’s Asian allies to assess what the North Koreans had done. The United States sent aloft aircraft equipped with delicate sensors that may, depending on the winds, be able to determine whether it was a plutonium or uranium weapon. The Japanese defense minister, Itsunori Onodera, said Japan had ordered the dispatch of an Air Self-Defense Force jet to monitor for radioactivity in Japanese airspace. Japan’s new prime minister, Shinzo Abe, told Parliament that the country was considering ‘its own actions, including sanctions, to resolve this and other issues.’”

Yet as with so many incidents with North Korea in the past, this move was designed to provoke rather than initiate any sustained aggressive action and the markets will likely shrug off the developments as the day proceeds. USD/JPY has recovered the 94.00 figure and could make another challenge on the 94.50 figure. A break there would open the path towards the psychologically key 95.00 level that is likely to attract a massive amount of speculative interest.

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