Speaking of seven-month lows, did anyone notice that while the US Dollar was busy declining against pretty much every other tradable currency that the Japanese Yen was doing the same? The Yen has remained rangebound against the Dollar for the last three months - the period during which the market rally and Dollar decline have taken place - which just by simple mathematics explains why it has also fallen to a seven-month low around the same time.

The same set of factors that caused the Yen and Dollar to move in lockstep prior to the credit crisis seems to have coalesced again in March. Specifically, investor comfort with risk-taking have combined with low rates to make both very attractive candidates for carry trade funding currencies. Both countries’ Central Banks are holding rates close to 0% (for several years now, in the case of Japan) and appear unlikely to hike them anytime soon. Simply put, ” ‘Risk appetite is improving in the market, which has been attracting cash away from safe-haven currencies like the dollar’ and the yen. Investors are ‘searching for higher yields.’ ”

At the same time, both countries have been aggressive in using fiscal and monetary policy to tackle the economic downturn, both of which could be highly inflationary and lead to currency debasement. Then, again, nearly every economy has responded with the same policy measures, which suggests that low interest rates represent the most plausible factor. It could, however, explain why the Yen is rising against the Dollar, and is closing in on the 13-year high recorded earlier this year. In other words, while both currencies are being sold in the short-term to fund carry trades, investors may have determined that the Dollar will remain weaker in the long-term, due to inflation problems.

On a certain level, this is somewhat baffling. Japanese economic indicators make the US economic recession look like an economic boom by comparison. “Preliminary figures showed the world’s second-largest economy shrank at a record 15.2 percent annual pace last quarter,” which would be the worst on record. Meanwhile, Japanese corporations saw so-called recurring profits fall by “69.0 percent from a year earlier to 4.27 trillion yen (44.35 billion dollars) in the three months to March…the sharpest drop since comparable figures became available in 1955 and the seventh straight quarter of declines…Combined sales reported by corporate Japan both at home and abroad caved by a record 20.4 percent.”

In addition, the US has recorded a net capital account surplus with Japan of late, which implies that Japanese are net investors in the US- not the other way around. The government of Japan is equally confused, and is “in the middle of analyzing what is driving the yen higher.” Still, it insists that forex intervention is not currently on the table. If Japan’s economy contracts by another 15% next quarter, however, I wouldn’t be surprised if it did an about-face.

This week, the Yen continued its decline against the Dollar and Euro, dipping well below 100 Yen/Dollar en route to a six-month low. Most analysts attribute this trend to a pickup in risk aversion: “Some kind of optimism is returning to the market and that’s putting pressure on the yen,” explained one analyst succinctly.

An ongoing rally in stocks and commodities is reinforcing investor attitudes that the economic recession is under control, and is stimulating risk-taking. In other words, the same forces that contributed to the unwinding of the carry trade during the beginning of the credit crisis, are now working in reverse and causing investors to flee from the Yen en masse. “As long as stocks can retain their buoyancy… risk appetite and risk-based trades will be in vogue and investors will continue to add to and rebuild yen short positions.”

According to the most recent International Monetary Market report, “Short positions on the currency have been building up for three consecutive weeks, and are now at levels last seen in the late summer of 2008,” which means the Yen’s slide has basically become self-fulfilling. From a technical standpoint, “A move above 101.00 yen was technically significant as it was a 38.2 percent Fibonacci retracement of its decline from a peak in 2007 to its 13-year low in January.” Even domestic Japanese investors have signaled their bearishness by taking advantage of last week’s Yen upswing by making “aggressive purchases of foreign bonds.”

From a fundamental standpoint, the decline in the Yen makes sense, given the abysmal economic situation in Japan. In fact, the “Minutes from the Bank of Japan’s March meeting showed members of the central bank were leaning toward cutting the bank’s economic forecast in April, and that they believed the BOJ would need to continue to provide substantial liquidity to financial markets that they see as still under substantial stress.”

The government is finally responding to the economic crisis, having most recently unveiled a $150 Billion plan, to supplement the $100 Billion initiative announced earlier this year. “If implemented competently, these steps could stabilize the domestic economy and stop the bleeding in labor markets.” At the same time, the intertwined tailspin in confidence and spending suggest that the government’s efforts could be in vain.

While equity investors have reacted positively - pushing the stock market into positive territory for the year- bond and currency traders are understandably concerned. Yields on Japanese bonds are already rising in anticipation of $100 Billion in bonds that the government will have to issue in 2009 alone. Naturally, the burden to purchase these bonds will fall on the Bank of Japan, which will be forced to print money and contribute to the further devaluation of the Yen in the process.

Ultimately, the duration of the Yen’s slide depends on the duration of the global stock market rally. If you believe that the global economy has turned a corner, then the Yen is done. If, on the other hand, you are inclined to side with George Soros, who opined recently that “It’s a bear-market rally because we have not yet turned the economy around,” then there is still cause for Yen bullishness.

This week marked a couple milestones for the Japanese Yen. First, the Yen fell below 100 JPY/USD for the first time in five months. Second, the Central Bank of Japan “celebrated” five years of not having intervened in forex markets. Of course, the relationship between these two events is not difficult to ascertain; as the Yen retreats from the stratospheric highs of 2008, intervention is becoming progressively less necessary (and hence less likely).

Risk aversion, or in this case a decline thereof, has been identified as the likely cause of Yen weakness, although as I alluded in an earlier post, there is still a question of causation, as opposed to correlation. Is it higher equity and commodity prices that are driving risk tolerance, or the other way around?

Regardless of whether the chicken or the egg comes first, higher asset prices have recently been accompanied by modest declines in so-called “safe haven currencies,” namely the Dollar and the Yen. In the case of the Yen, there were previously two different narratives, one that underlies the Yen’s performance solely against the Dollar, and another thread seems to govern its fluctuations against virtually all other currencies.

In recent weeks, however, a combination of forces have come together to drive the Yen down against all currencies. First, of course, is the theme of declining risk aversion: ” ‘The euro was bought for the yen on the back of recent firm stock markets and this supported the dollar relative to the yen,’ ” summarized one analyst. The $1 Trillion economic stimulus plan unveiled today by the G20 will also have the effect of “sapping demand for Japan’s currency as a refuge.”

There are also end-of-quarter factors that have played a role in the Yen’s decline. ” ‘The dollar is being buoyed as Japanese investors try to secure currency on the last day of the fiscal year. Investors’ demand for the yen stemming from repatriation flows, on the other hand, appears to have peaked,’ said a trader at a Japanese bank.”

Last but not least, there is the Japanese macroeconomic picture, which shows a country that is headed towards a deep recession. The latest monthly figures show a 49% year-over-year decline in exports, which is contributing to rising pessimism among Japanese businesses. According to a recent survey by the Bank of Japan, “Confidence among Japan’s large manufacturers dropped to minus 55 in March from minus 24 in December, [which]…would be the lowest since 1975 and the biggest drop since the bank started the survey.” Given that Japanese household spending is also falling, “Japanese companies are caught in a double bind, facing markets at home that are shrinking with the population as well as the global downturn.”

In the wake of the Swiss National Bank intervening to hold down the value of the Franc, everyone is wondering whether the Bank of Japan (and perhaps other Central Banks) will follow suit. Asks one market commentator rhetorically: “How long do you think it will be until Japan tries once again to push the yen lower, with its export industries in tatters?” Given that the Japanese economy is forecast to contract for at least the next two quarters, and also that its trade balance recently slipped into deficit, this is an eminently reasonable question.

Even prior to the surprise SNB announcement, it was widely speculated that the Bank of Japan would intervene on behalf of the Yen. After all, the BOJ was the most recent Central Bank to have waded into forex markets; it unsuccessfully spent $350 Billion in 2003-2004 to hold down the Yen. Since the inception of the credit crisis, however, it has passed on several golden opportunities. “It declined to intervene in October when the Group of Seven industrial powers issued a rare inter-meeting statement singling out yen volatility, giving Japanese authorities the green light to stem its surge. Even when the yen hit a 13 1/2-year high of 87.10 per dollar in January and exports demand collapsed, the BOJ held back.”

Since the beginning of 2009, the Yen has fallen 8% against the Dollar, and has fallen to a 3-month low against the Euro. Now, the “pendulum is swinging the other way” as risk aversion eases up and investors turn their attention to macroeconomic fundamentals. “The yen’s safe-haven appeal has, however, lost some of its lustre due to a rapid deterioration in Japan’s economy…and political uncertainty with an unpopular government facing an election that must be held by October.”

Nonetheless, the Yen has not yet slipped below the psychologically important 100 Yen/Dollar barrier. Analysts speculate that this is due to capital repatriation by Japanese investors, for hedging and accounting purposes. In order to minimize forex conversion losses, Japanese retail investors are taking advantage of the relatively weak Yen by shifting funds into domestic value stocks. Japanese companies, meanwhile, are ” ‘dressing up’ their balance sheets ahead of their fiscal year-end, by liquidating foreign holdings and bringing home the profits from overseas subsidiaries, to raise their bottom lines.”

The likelihood of BOJ intervention is paradoxical. If investors fear intervention, they will sell the Yen, and in turn, minimize the need for intervention. On the other hand, if investors remain skeptical of intervention, they may buy the Yen, which could actually impel the BOJ to intervene. But putting game theory aside, most analysts remain convinced that economic and political circumstances point away from intervention as a real possibility.

The Japanese Yen is increasingly resembling a patient with split personality disorder, moving in one direction (down) against the Dollar while behaving quite differently against other currencies.

For most of the duration of the credit crisis, the Yen had mirrored the performance of the Dollar, both of which had performed well as so-called “safe-haven” currencies. For a while, the Yen even outpaced the Dollar, rising to a 13-year+ high. Over the last five weeks, however, the Yen has fallen off against the Greenback, while maintaining its value against other rivals. It’s unclear exactly what’s driving this split, but careful analysis suggests it is a product of changed investor psychology.

To elaborate, the Yen’s precipitous rise was due to financial- as opposed to economic- factors. As investors fled emerging markets en masse and unwound carry trades, it spurred a flood of capital back into Japan. This was not because the Yen was anything special; far from it, in fact. Rather, it was because the alternatives were perceived to be substantially more risky. This began to change in earnest when it was revealed that the Japanese economy shunk by over 12% (on an annualized basis) in the recent quarter. Given that Japan’s economy is famously dependent on exports, it didn’t take long for investors to connect Japan’s sagging GDP with its strong currency.

This prompted speculation that Japan would intervene in forex markets in order to prevent the Yen from rising further. In the end, Japan didn’t spend a dime. Fortunately, it didn’t have to, as investors took the hint, and sent the Yen tumbling against the Dollar. Technically, Japan hasn’t intervened since 2004 (see chart), but the threat of intervention combined with low interest rates ensured that in this case, words spoke just as loud as actions. It should be noted that Japan will use a small portion of its reserves to fund domestic economic initatives, but for now at least, none of it will be used to purchase Dollars in the spot market.

So why hasn’t the Yen reversed course against other currencies? Its stock market is sagging, and its economy is in equally bad, if not worse-than-average shape. The answer lies in interest rate differentials and investor risk tolerance. The rate gap between the Yen and the highest-yielding currency (New Zealand), has shrunk to less than 3.5%. Excluding Australia, and to a lesser extent the Euro, interest rate differentials are effectively negligible. Accordingly, investors have decided that the gains from an additional couple hundred basis points in yield are not offset by the perceived increase in risk associated with currency volatility. That this theory holds water is evidenced by the fall in the Japanese Yen that immediately registered when the Bank of Australia opted to hold rates steady at its most recent meeting.

A reversal of the yen, from strength to weakness, will have “major global implications…” Perhaps beleaguered Japanese authorities already have begun reacting to the “carnage” the yen’s rise has wrought.

After months of speculation, it appears that forex markets have finally concluded that the Central Bank of Japan is now prepared to bring down the Yen. On the one hand, the Finance Minister of Japan very publicly denied that the overvalued Yen and the consequent need for forex intervention was discussed during either his personal conversation with US Treasury Secretary Geithner or at the most recent G7 conference. At the same time, he pledged the willingness of Japan to fight “excessive swings” in forex and capital markets. Meanwhile, the expensive Japanese Yen has already trickled down to the economy, driving a 12.7% decline in GDP (in annualized terms) for the most recent quarter. The Yen, accordingly, has begun its retreat, already erasing nearly 10% of the gains it racked up against the Dollar over the last year. Reuters reports:

Read More:  Japan to act vs FX swings

While continuing to deny the possibility of direct forex intervention, Japan is nonetheless desperate to halt the rise in the Yen. The primary concern of the US government, meanwhile, is not that the Dollar is becoming too valuable, but rather that it will face great difficulty in funding its economic stimulus plan. Perhaps there exists a golden opportunity to simultaneously alleviate both of these quandaries; Japan should be solicited to buy US government bonds. A large-scale purchase of US Treasury securities by the Central Bank of Japan would be tantamount to intervention, and would probably lead to a decline in the Yen, at least against the Dollar. Of course the US would benefit not only by the direct purchase of its bonds, but also by the positive signal that this would send to other institutional investors. Besides, given that China is in no position to increase its holdings of US Treasury securities, Japan represents the best candidate for partnership. The Washington Post reports:

Achieving such a currency adjustment may seem farfetched, but the yen-dollar exchange rate historically has been heavily influenced by the market's perception of the U.S. and Japanese governments' comfort level for the currency relationship.

Read More: America's New Rescuer: Japan

In accordance with yesterday's post, it appears that this February is set to continue the trend of low volatility observed in previous years. With the US government on the verge of passing a record economic stimulus package, investors are becoming increasingly confident about the prospects of the global economy to avoid recession. On the surface, it would seem that the stimulus should benefit the economy, and by extension the Dollar. However, this ignores the fact that the Dollar is currently being driven by fear- the idea that the US remains a safe haven for investing- rather than by economic fundamentals. The same holds true for the Japanese Yen. Accordingly, regardless of how the stimulus ultimately impacts the economy, it will certainly increase risk tolerance in capital markets, potentially leading investors to shift capital out of the US and Japan into higher-yielding sectors. Bloomberg News reports:

"A lot of money that sat on the sideline is now being put back to work," said [one analyst]. "People are starting to move to make risky bets."

Read More: Yen, Dollar Fall as U.S. Stimulus Prospects Reduce Haven Demand

Efficient markets theory would suggest that the inherent randomness of commodity prices should be preserved from month to month, such that on average, prices are equally likely to go up as they are to fall. In practice, we know that earnings and tax calenders are such that stocks consistently perform better in some months, than they do in others. Such patterns can also be observed in forex markets.The Dollar, for example, typically rises in January, probably as a result of the US stock market to rise likewise. In February, meanwhile, one analyst has observed a consistent decline in volatility between the Yen and the Dollar. The implication is that with lower volatility will follow a sell-off in the Yen, due to renewed interest in the carry trade. Of course, this may not hold in the current market environment, as both currencies are now being used to fund carry trades and are being punished accordingly when risk tolerance increases.

Read More: What Is Unique About Forex in February?

Despite backed by negative real interest rates, the Japanese Yen continues to grind upwards, threatening to break through significant psychological and technical barriers. From a monetary standpoint, the Bank of Japan is basically out of options with regard to limiting the currency's upward momentum. Its sole remaining tool is its $1 Trillion in foreign exchange reserves, which it could release directly into currency markets to depress the Yen. It has been four years since Japan last employed such a strategy, and it appears reluctant to dip into the reserves again for fear of offending the G8, which has discouraged such action. The BOJ is also reluctant to build its holdings of US Treasuries (which would be a collateral requirement of holding down the Yen), because bond prices have become inflated. However, loss of face may soon become the least of its concerns, as the economy slides deeper into recession. Unless the notoriously thrifty Japanese consumers can be impelled to action, the Bank may find it has no other choice but to spur the export sector via a cheaper Yen. The Guardian UK reports:

The economic malaise in the United States and Europe is affecting Japan and Tokyo must act to keep the economy afloat, Nakagawa said, a day after the country's central bank forecast that Japan would plunge into its deepest contraction in modern times.

Read More: Japan steps up warning on markets, BOJ gloomy

While the Yen's 30% rise in 2008 is no mystery (a result of the unwinding of carry trades), its performance nonetheless defies economic fundamentals. Exports have fallen and industrial production has collapsed, such that recession now appears inevitable. Japan is not alone in this regard, as a number of economies have suffered unnecessarily as a result of excessive volatility in currency markets. The solution could be the so-called "Tobin tax," which aims to limit forex speculation by levying a nominal tax on short-term currency trades. The proceeds from such a tax would be used to restore some equilibrium in forex markets by providing Central Banks with funds for direct intervention. While the tax itself has never been implemented, countries have previously taken to cooperating on forex matters for the sake of global macroeconomic stability. Seeking Alpha reports:

Exchange rates have to be within a certain range for all economies to prosper. The major economies have to work together to ensure this. If the Group of Five could work together to depreciate the "Super Dollar" in 1985, so the major nations today can and should work together to stem the surge of the super Yen.

Read More: Japanese Yen: An Excessively Strong Currency Spells Recession

On the basis of a 25% appreciation against the Dollar, 2008 marked the strongest year for the Japanese Yen since 1972, as the credit crisis caused a rapid unwinding of carry trades as investors abandoned risky positions. 2009 may not be as auspicious for the Yen, however, as a bevy of factors coalesces to halt its upward progress. First of all, global credit and forex markets have begun to stabilize over the last few months. The seemingly unending US government bailout has restored confidence in riskier sectors, such as the automotive sector. Coupled with a cut in Japanese interest rates, investors are being lured back into the carry trade. In addition, Japanese economic officials are becoming more vocal about the Yen's rise, which is threatening to send the export-dependent economy into another deep recession. It is therefore conceivable that the Central Bank could intervene on behalf of the Yen, despite the pleas of the G8. Bloomberg News reports:

The last time Japan intervened on its own, it sold a record 20.4 trillion yen ($226 billion) in 2003 and 14.8 trillion yen in the first quarter of 2004, when the yen rose as high as 103.42 per dollar.

Read More: Yen Weakens as Carmaker Loans Revive Confidence in Carry Trades

If ever there was a case for Japanese intervention in forex markets, it is now. The Yen has emerged as the unquestionable victor from the credit crisis, having appreciated against every major currency and notching a 13-year high against the Dollar. Japanese exports have plunged, inducing the country's first monthly trade deficit in almost three decades. Meanwhile, corporate profits are sagging as a result of forex conversion losses, and the unemployment rate could soon set a new record. Notwithstanding comments to the contrary by a high-ranking official, however, the Central bank of Japan is perhaps unlikely to intervene on behalf of the Yen, if only for political reasons. The G7 countries, namely the US, have urged Japan to allow the market to run its course, as it hopes the weaker Yen can help restore some of America's export competitiveness. The Asia Times reports:

Japan will be criticized internationally, especially by the US, the country's strongest ally, if it acts to stem the currency's gain as US automakers are still on the brink of bankruptcy. The stronger yen drives up the price of cars imported to the US.

Read More: Japan to live with yen burden

The last two weeks have proved the old adage, "What goes up must come down." In other words, the year-long Dollar rally has begun to fade, as investors once again embrace economic reality. Previously, Dollar strength could be largely attributed to exit trades out of other currencies, rather than any substantive benefit of investing in the US. Now, risk appetite is slowly recovering, having received a boost from the just-completed government bailout of the US automobile industry. Less concerned about risk/volatility, investors have taken to re-assessing economic fundamentals. In the case of the US, unemployment is rising, the twin deficits continue to expand at a breakneck pace, and the interest rate disparity between the ECB and Fed will remain in place for the near-term. The Wall Street Journal reports:

Whether the dollar will continue to weaken is a matter of debate. Currency strategists caution that the dollar often is weaker toward the end of the year, particularly against the euro, as companies and investors adjust bets.

Read More: Less Panic Puts Pressure on Dollar

Officially, Japan has not intervened in forex markets since 2004, when it spent the equivalent of $300 Billion to hold down the value of the Yen. That impressive streak could soon come to and end, however, as the Yen continues to surge on the unwinding of the carry trade. The performance of the Yen- which recently touched a 13-year high- is particularly impressive since it comes at a time when virtually every other currency has collapsed relative to the US Dollar. Now, analysts have once again taken to pouring over monthly data on Japan’s Central Banking activities, in order to confirm that it is keeping its finger off of the trigger. Given that the Yen’s appreciation has already prompted several high-level meetings among global economic and political leaders, however, it is probably only a matter of time before Japan ends its multi-year abstinence from forex. Reuters reports:

Japanese Finance Minister said earlier this month that the authorities must be ready to deal with big swings in markets as they are undesirable. His comments pushed the yen lower against the dollar as market players were wary of intervention.

Read More: Japan did not intervene in currency market in Nov

Most of the commentary surrounding the dual Dollar-Yen rally that has unfolded over the last couple months has focused around monetary policy and risk aversion. Accordingly, the prevailing theory is that both currencies are being driven upwards because of narrowing interest rate differentials and a collapse in risk tolerance. However, it’s also important to consider the role of technical/financial factors. Specifically, liquidity in forex markets is dissipating rapidly as market participants have found it difficult to secure lines of credit to finance leveraged currency trades. In addition, those with leveraged short positions in the Dollar and Yen have been forced to partially unwind their positions for the same reason. In hindsight, the decline in both the Dollar and the Yen over the last few years now appears to have been driven primarily by the same expansion in credit that underlied the real estate bubble, which enabled traders to take advantage of interest rate differentials to earn relatively risk-free profits from a carry trade strategy. Regardless of the fact that these interest rate differentials persist and a carry trade strategy remains theoretically viable, it’s becoming impossible to undertake because of a shortage of credit and liquidity. FX Solutions reports:

The credit crash has affected participation rates in all markets. Many speculative players who depended on credit and leverage to fuel their trading have withdrawn. They will not return anytime soon. In the currency markets this permanent drop in liquidity may keep price movement volatile long after calm has returned to other markets. It has substantially diminished liquidity in the yen crosses which were, for so long, the speculative favorites of currency traders.

Read More: Volatility and the Carry Trade

These days, the Dollar and the Yen are veritable proxies for investor confidence/risk tolerance. As a result, on days when US stocks rise, the Dollar (somewhat ironically) will typically experience a decline. Over the last couple weeks, it should therefore come as no surprise that the tremendous rise in US stock prices was matched by a proportional fall in both the Dollar and the Yen. If only for technical reasons (i.e. that the scale tipped too much in the other direction), it seems investors have regained some of their comfort with investing in emerging markets, leading some of the hardest-hit currencies (Korean Won, Brazilian Real, Mexican Peso) to recover some of their gains. Call it wishful thinking, but some investors now believe that the US recession will be milder than originally forecast, which would certainly exert a positive impact on such emerging market economies. In addition, there were monetary factors underlying the currency reversal, reports The Washington Post:

There were more specific reasons for some of the fluctuations. A news report that the Bank of Japan might cut rates in the near future was a factor in driving down the yen.

Read More: Currency Swings Reverse Course

The G7 Industrialized Nations met today in Tokyo to discuss the credit crisis, with a focus on its impact on forex markets. The Japanese Yen, specifically, has exploded in recent weeks, as nervous investors have fled emerging markets and other risky sectors, and have unwound carry trades (funded with Yen) in the process. Evidently, this is wrecking havoc on the Japanese economy, which has a notoriously frail domestic sector and is heavily reliant on exports to drive growth. The Central Bank of Japan has recently threatened intervention, and now that the G7 is presumably on board, it may do just that. The New York Times reports:

The statement, which said the G-7 would "monitor the markets closely and cooperate as appropriate," came as countries in Asia, spooked by the relentless sell-offs in the stock markets, scrambled to support their economies.

Read More: Group of 7 Meeting in Tokyo Tackles Yen’s Rise

In times of financial crisis, investors can reasonably be expected to park their money in the least risky capital markets. In this case, that means those in the US and Japan. Compare this so-called "safe haven" trade with the "carry trade" that preponderated in previous years, as investors shifted capital away from Japan in order to earn higher yields. Now, as volatility surges to dangerous levels, investors are going to increasingly great lengths to mitigate risk. At least until the negotiations surrounding the US government bailout are resolved (whether in success or failure), big bets are off the table. In other words, few investors continue to scour the globe for yield, which eliminates the raison d’etre of the carry trade. Bloomberg News reports:

"These are not the right times to be putting on any bold trades because it’s the perfect environment for getting whipsawed,” said [one analyst]. "I think waiting on the sidelines is probably the most prudent thing to do.”

Read More: Yen Posts Biggest Weekly Gain Since May on Bailout Clash, WaMu

Over the last couple months, the Dollar has notched some impressive returns against nearly all major currencies, including a 13% gain against its chief rival, the Euro. Nearly is italicized because the pack includes a lone stray-the Japanese Yen-which has managed to maintain most of its value during the Dollar rally. The Yen has benefited from the same trend towards risk aversion that has underlied the Dollar’s strength. Because of the preponderance of carry trades which utilize Yen as a funding currency, spikes in volatility tend to benefit the Yen disproportionately as skittish investors unwind their Yen-short positions. Even excluding volatility, a global easing of monetary policy (including recent cuts in Australia and New Zealand) has lowered yield differentials and made the carry trade far less lucrative. In any event, the Yen now finds itself locked in an epic battle with the Dollar to determine which currency is the least risky in times of crisis. The Wall Street Journal reports:

"As we’ve seen during past episodes of risk aversion and the unwinding of risk trades, some of those were funded with the yen. As those were unwound it involves buying back the yen and it appreciated against a lot of currencies."

Read More: Clash of the Titans: The Dollar and Yen

The Yen has been hammered over the last month, by both the sudden strength of the Dollar and increasing comfort with risk-taking. Now that the US government is set to bail out the two American mortgage giants, Fannie Mae and Freddie Mac, investors are likely to become even more confident that the global economy is in strong enough shape to weather the credit crisis. As demand for risky investments- such as stocks and high-yielding currencies- grows, the Yen (because of low interest rates) will once again find itself as one of the main funding currencies for the carry trade. Of course, risk-aversion is a two-way street, and one stumble in the US economy, for example, would benefit the Yen. Bloomberg News reports:

"The yen is likely to take a hit. A government bailout will certainly stabilize Freddie and Fannie and improve risk appetite for carry trades."

Read More: Yen Drops Most in 3 Months as U.S. Takes Over Fannie, Freddie

When the credit crisis kicked off in 2007, many online forex traders and economic analysts quietly began to circulate the theory of "decoupling," which asserted the global economy was strong enough to weather a downturn in the US economy. In other words, it was expected that the credit crisis would be contained within the US, and the rest of the world would plod along, unaffected. This notion now appears to be completely without merit, except in a few isolated cases.

Instead, economies from Europe to Asia are sinking, and sinking fast. Some economies, namely Japan and Germany, have even begun to contract! Canada and Australia may slide into recession, regardless of what happens in commodity markets. Within this context, the Dollar’s 10% rally is not much of a mystery. In other words, this rally is probably more a function of economic weakness in other countries than of US economic strength. In addition, the end of de-coupling works both ways; a global economic downturn could further harm the US. A wave of negative economic data and/or the next round of debt write-downs could send the Dollar spiraling downwards. The Telegraph reports:

We are not witnessing a dollar rally so much as a collapse in European and commodity currencies. The race to the bottom has begun in earnest.

Read More: Dollar surge will not stop America feeling the effects of a global crunch

As the credit crisis has unfolded, the Dollar has remained (relatively) strong, especially considering the deteriorating state of its economy. The reason for this, of course, is that in times of crisis, investors flock to perceived safe havens, such as the US and EU. However, an especially pessimistic series of economic developments has called into question the wiseness of this strategy. A handful of American banks and mortgage institutions have already collapsed, and bankruptcies in all sectors of the economy will surely become more common. The picture in Europe is equally bleak. Several economic indicators have fallen to multi-year lows, and the ECB’s decision to hike rates looks increasingly misguided. Given these circumstances, where can investors turn? Perhaps, to Japan and Switzerland, reports The Market Oracle:

The Swiss franc and the Japanese yen…were the great beneficiaries during the Crash of ‘87, the Debt Crisis of 1998 and again during the current credit crisis, enjoying sweeping and massive upward moves.

Read More: Crisis Currencies Poised to Surge as Frightened Capital Flows from Risk to Safety

Volatility, the perennial enemy of the carry trade, has returned with a vengeance. The US stock market, a proxy for global risk appetite, has fallen significantly (nearly 20%) over the last six months, a trend that has accelerated over the last two weeks. By no coincidence, the Japanese Yen and Swiss Franc have rallied dramatically over the same time period. On one hand, currency trading is seemingly becoming more cut-and-dried, as correlations strengthen between different sectors of the global capital markets and specific currencies. The respective inverse relationships between the Dollar and oil, and between the Yen and US stocks, have been particularly strong of late. In the end, though, it is anyone’s best guess whether the price of oil will continue to rise and stocks will continue to fall. Reuters reports:

"We’re back on the brink," said one analyst. "It seems there is a feeling of resignation and helplessness amid this credit crisis."

Read More: Yen and Swiss franc gain as risk appetite fades

Most of the stories and analysis featured on the Forex Blog concern the Dollar, or at the very least, how other currencies are performing relative to the Dollar. But there are many important currency pairs that don’t involve the Greenback, including the Euro/Yen. Last week, the Euro climbed to its highest level in 2008 against the Yen, thanks to diverging economies and interest rates. Neither economy is particularly strong, but the Bank of Japan is using especially bearish language to describe its faltering economy. It should be noted that despite a prolonged period of economic growth, the Bank of Japan avoided raising interest rates even once. Meanwhile, the European Central Bank is becoming increasingly hawkish in its monetary policy rhetoric. The result has been a sustained (and soon-to-widen) interest rate differential, which has contributed to a dynamic that is unique to these two currencies. Bloomberg News reports:

The yen fell against every major counterpart today after a government report showed Japan’s longest postwar expansion may be over.

Read More: Euro Climbs to Year’s Highest Against Yen on Rate Speculation

"The credit crisis is over! No it’s not! Yes it is!"

Such back and forth represents the tenor of the debate currently transpiring in the financial markets. Every day seems to bring new economic data, which is quickly seized upon by both sides as evidence for their respective positions, causing the markets to rise and fall accordingly. In this regard, the Japanese Yen and the Swiss Franc serve as proxies for investor sentiment. When the markets rally, investors are quick to dump both currencies in favor of higher-yielding alternatives. On the other hand, when a large investment bank announces a write-down on its subprime investments, or when economic data indicate falling housing prices, investors are quick to unwind their short positions (carry trades). The advice of the Forex Blog is to take every development in stride and to remember that no definitive conclusions can be reached at this point.

Read More: Yen Weakens on Speculation Worst of Financial Crisis Is Over

Volatility levels on JPY/AUD forward contracts recently jumped to 25%, the highest level since the Asian financial crisis of 1997-1998.  Combined with other factors, this suggests that the JPY/AUD carry trade, whereby investors borrow in low-yield Yen in order to invest in high-yield Australian Dollars, may be coming to an end.  Economic indicators show a faltering Australian economy, sagging confidence, and a record trade deficit.  Meanwhile, inflation has moderated, such that it is unlikely that the Royal Bank of Australia will hike rates any further and enhance the nation’s comparatively attractive yields.  Even though the interest rate differential between Australia and Japan remains a healthy 6.75%, investors may deem this inadequate compensation for the risk implied by weak economic fundamentals. Bloomberg News reports:

"For the next one or two quarters, the Aussie’s fundamentals will probably look very soggy. I would suggest the Aussie dollar is expensive. There has been a stunning shift back in favor of the yen," [said one analyst].

Read More: Australian Dollar May Fall 10%, Suncorp-Metway Says

For several months, the Central Bank of Japan had been leaderless, creating a situation that was politically and economically awkward.  Finally, after much debate, Masaaki Shirakawa, a former academic and veteran central banker, was appointed.  It is unclear what effect Mr. Shirakawa will have on Japan’s economy, which is foundering (for reasons unrelated to the global credit crunch).  He is considered highly competent, and analysts have suggested that he could help Japan develop a sensible and focused economic policy, which has been lacking for quite a while. With regard to monetary policy, he is unlikely to either raise or lower interest rates from the current level of .5%.  Thus, if he is to return Japan to economic credibility, he will have to use other methods. Nonetheless, analysts are optimistic. The New York Times reports:

Simply having a hand at the central bank’s tiller will do much to restore global confidence in Japan and its ability to manage its $5 trillion economy, economists and former bank officials said.

Read More: Japan Approves New Bank Chief

After the Fed cut its benchmark lending rate by 75 basis points last week, the Dollar immediately rallied 2.5% against the Japanese Yen, marking its highest daily rise in nine years.  Some analysts are at a loss to explain this phenomenon, since a narrower interest rate differential should have produced the opposite effect.  Perhaps, the answer can be found in the carry trade, whereby investors sell Yen in favor of higher-yielding currencies.  Support for the carry trade typically moves inversely with volatility.  For example, when risk aversion rises due to economic uncertainty, investors typically unwind their carry trade positions.  With the Fed rate cut last week, however, risk aversion actually fell, and the S&P 500 Index surged.  By no coincidence, the Yen fell. Reuters reports:

As U.S. stocks rallied, with investors willing to take on more risk, the dollar recouped some of Monday’s sharp losses versus the low-yielding yen.

Read More: Dollar posts biggest gain vs yen in nine years

Yesterday, the Forex Blog reported that the risk of intervention in forex markets is growing, in order to prop up an ailing Dollar.  The focus of the post was on the Euro, which is hovering below the record high of $1.60 reached last week. With this post, we wish to extend coverage of the potential intervention to include Japan.  In some respects, Japan is actually a more likely candidate for intervention, since it has a history of actively depressing its currency.  Most recently, in 2004, it accumulated $350 Billion in Dollar-denominated assets in a large scale effort to keep the Yen from rising out of control. 

Japan’s consumers are notoriously tightfisted, and consequently, its economy is dependent on the export sector to drive growth. Unfortunately, the more expensive Yen is making this sector less competitive. In addition, Japan’s new Prime Minister has yet to lay out an economic plan, and the stock market is foundering. A number of creative solutions are being mulled, including one to buy American mortgage-backed securities, in order to head off the international opposition to intervention. The New York Times reports:

That might win Washington’s approval by helping to ease the credit squeeze in the United States, but given such securities’ role in precipitating the crisis of the last several months, it might well set off cries of dismay here.

Read More: As Dollar Keeps Falling, Talk of a Move by Japan

Over the weekend, Bear Stearns, a prestigious American investment bank, hurriedly scrambled to find a buyer in order to avoid having to file for bankruptcy. While a buyer (JP Morgan) was ultimately secured, investors remained jittery, as the collapse of this magnitude is virtually unprecedented.  When forex markets re-opened on Monday, the Dollar crashed against all of the world’s major currencies, namely the Euro and the Yen. Furthermore, analysts are now beginning to view forex intervention as increasingly likely. It’s still unclear whether the Bank of Japan or the European Central Bank (with or without support from the Fed) would spearhead any such intervention.  At the breakneck speed at which events are unfolding, however, no one will be surprised if a plan is quickly cobbled together. The Wall Street Journal reports:

"Were such intervention to be seen, (the euro) could briefly trade down to $1.55, yet unless the (ECB) is prepared to back up such intervention with a rate cut, intervention will be futile," said [one analyst].

Read More: Dollar’s Slide Keeps Pace

In recent periods of Dollar Weakness, all of the major currencies have been quick to capitalize- all but the Japanese Yen.  After a while, it became clear that the Yen was being held down by carry traders, who sold Yen in favor of higher-yielding, more risky currencies.  It was long believed that the only thing that would shake the Yen loose from its moorings was not a Japanese interest rate hike or economic growth, but volatility in capital and forex markets.  Sure enough, the explosion of the credit crisis induced a rapid appreciation in the Yen.  Yesterday, it crashed through the psychological milestone of 100 for the first time since 1995.

But can the Yen sustain this momentum? On paper, if the Dollar continues to fall, it seems the answer is ‘Yes.’ However, Japan’s economy is extremely dependent on exports. In fact, 50% of its 2007 GDP growth can be attributed to exports. With the Dollar crashing, Japan’s exports are becoming less competitive, and its exports to the US (estimated at $150 Billion) are in jeopardy. In addition, Japanese consumers are notoriously tight-fisted, so it’s unclear who would pick up the slack if the export sector falters.  This begs another question: will the Bank of Japan be forced to intervene in currency markets (like it did in 1995) in order to prevent its economy from dipping into recession? The Wall Street Journal reports:

Its big budget deficit makes a stimulus package more difficult. Intervention — which Tokyo also tried in 2004 during a bout of yen strength — would fly in the face of efforts by the U.S. and other nations to let markets decide currency values.

Read More: Japan Economy Quakes Anew As Yen Soars Against Dollar

Most of the world’s major currencies are affected by a variety of technical and fundamental factors, such that only taking into account one factor is tantamount to using P/E multiples as the sole basis for purchasing shares of stock. The New Zealand Dollar, which barely qualifies as a major currency seems to be one of the few exceptions to this common sense rule.  The preponderance of carry traders involved in trading the Yen ensures that the NZD inversely tracks the Japanese Yen.  In addition, the demand for Kiwi is directly proportional to appetite for risk, such that when risk aversion declines, the Kiwi increases, and vice versa.  The reasoning is quite simple: the Kiwi boasts the highest interest rates in the industrialized world. Because the investment climate in New Zealand is less stable than in other industrialized countries, New Zealand often witnesses capital flight during periods of global economic uncertainty.  The New Zealand Herald reports:

Gains in equities markets emboldened investors to take chances, prompting use of the low-yielding yen to buy assets in higher-yielding currencies like the kiwi in carry trades.

Read More: Equities send dollar up

The US stock market has lost over 10% of its capitalization since reaching an all-time high in October of last year.  Meanwhile, the Japanese Yen has climbed at least as much in proportional terms since bottoming out around the same time.  Coincidence?  At least one analyst doesn’t think so. Because of the steadfast popularity of the carry trade, the Japanese Yen appears to have developed an inverse correlation with the US stock markets.  The reasoning is actually quite simple. When aversion to risk is low, investors borrow in Japanese Yen and make investments denominated in other currencies, the Dollar for one.  When risk-aversion increases, as it has in the current economic environment, investors have been quick to close out their carry trade positions, causing the Yen to rise. Maktoob Business reports:

If the situation of stock markets is improving, the USD/JPY is likely to be increasing. It means that more carry trade transaction are being carried out.

Read More: Fundamental analysis - Market Correlations

As Asian capital markets crash in unison, the Japanese Yen is rising at its fastest pace in years.  Taken out of context, that sounds like a contradiction, since a positive correlation typically obtains between the strength of a nation’s economy, capital markets, and currency.  However, the Yen is unique, as most forex traders are doubtlessly aware.  The Yen rises and falls with the whims of the carry trade, which in turn is tied closely to volatility.  And in case you haven’t noticed, global capital markets are seesawing to such an extent that by some measures, volatility levels have reached a nine-year high.  One analyst has drawn a parallel between the current credit crisis and the 1998 Asian economic crisis, which also produced a Yen rally.

Read More: History Points to a Yen Rally

Since July, the Japanese Yen has notched a stellar performance in climbing 15% against the Dollar, without garnering much attention.  Within the last week, however, analysts have begun to take notice, as the carry trade temporarily collapsed and the Yen appreciated by another 3%. ‘But Japan’s Central Bank is no hurry to raise interest rates,’ you are probably wondering. ‘What on earth is all the fuss about?’ Volatility, the sworn enemy of carry traders has exploded.  Global capital markets, including the US stock market, are in a state of turmoil. The financial services industry, the perennial bulwark of the US economy, is set to record its worst year in recent memory.  Leading the way, so-to-speak, is Citigroup, which recently announced that it will write-down an additional $10 Billion in worthless subprime paper and will also receive a proportionately large infusion of capital.  Cue exit music for carry traders. Bloomberg News reports:

"The global and risk environment is dominating yen pricing,” said Chris Turner, head of currency research at ING Financial Markets in London. "There’s risk aversion in the background.”

Read More: Yen Rises as Traders Pare Carry Trades on Credit-Market Losses

The Yen has received a nice boost from Japanese exporters, which moved en masse to exchange Dollars for Yen to meet certain year-end financial obligations.  The logic is that exporters had owed money in arrears to domestic Japanese producers of the goods and services being exported and needed to be paid in Yen. Such logic could theoretically be applied to exporters in ever country, which would provide the same boost to their respective currencies.   However, in addition to being the world’s fourth-largest exporter, Japan’s economy is unusually dependent on exports.  Thus, it is understandable that Japanese exporters could exert such influence on forex markets when entering the market at the same time.

Read More: Yen Rises on Speculation Japanese Exporters Buying the Currency

It’s been rough sailing for the Yen carry trade of late; the technique had been sagging in popularity due to the credit crunch and the associated trend towards risk aversion.  Over the last few weeks, however, the Yen has fallen, which is to say the Yen Carry Trade is making a comeback.  First came the announcement that the world’s leading Central Banks would be injecting hundreds of billions of dollars in the banking system, in order to ease growing liquidity concerns.  Next, the Bank of Japan hinted that it would hold rates at .5%, the lowest in the industrialized world.  Finally, a continued surge in commodity prices virtually ensures that countries rich in natural resources, such as Canada and Australia, remain viable "targets" for carry traders.  Overall, the story remains focused around volatility.  In fact, one investment bank discovered an inverse correlation between the S&P 500 and the Japanese Yen.  In other words, the appetite for risk appears closely correlated with the strength of global capital markets and the popularity of the Yen carry trade.  Bloomberg News reports:

Over the last fortnight, that odd correlation with equities has broken down…Instead the fundamental factors behind carry trades have come to the fore again. Investors are paying attention to Japan’s economy.

Read More: The resources to carry on

While covering the emergence of the carry trade over the last couple years, the Forex Blog has echoed the sentiments of the self-proclaimed experts, who argued that Japanese interest rates would never rise enough to seriously threaten the carry trade. Instead, any threats would have to come in the form of volatility, which would theoretically drive traders to spur the comparatively high returns of carry trading in favor of low risk.  As if on cue, the carry trade has retreated significantly as the credit crisis aka housing bubble shockwave has rippled through global capital markets.  As the negative fallout builds, many of the carry traders who braved the first storm are rushing for the exits.  Bloomberg News reports:

Volatility implied by dollar-yen currency options expiring in one week with a strike price near current levels rose to 13.25 percent… Traders quote implied volatility, a gauge of expected swings in exchange rates, as part of pricing options.

Read More: Yen Advances on Concern Credit Losses Will Deter Carry Trades

The carry trade is officially unwinding, if not coming to an outright end; the result is that the Yen is belatedly joining the ranks of the rest of the world’s major currencies, which have risen tremendously against the Dollar.  The reason for the sudden weakness in the carry trade (i.e. Yen strength) is volatility.  The US "credit crunch" began to significantly effect US bond and stock market valuations almost four months ago, but the full impact still hasn’t been felt.  The latest development concerns the quarterly earnings release for Freddie Mac, an American company whose main purpose is to provide liquidity to the US mortgage market, through the buying and selling of mortgage-backed securities.  However, Freddie Mac is now bleeding money, and while it is unofficially guaranteed by the federal government, investors are seriously questioning its ability to prop up the ailing market for housing CDOs.  And this uncertainty is causing investors to eschew risk, in short, to abandon the carry trade in favor of more traditional forex strategies.  Reuters reports:

The low-yielding Japanese currency tends to do well in times of risk aversion because investors unwind carry trades that use cheaply borrowed yen to buy higher-yielding currencies.

Read More: Dollar sinks to 2-year low vs yen, euro hits highs

Yesterday, the Financial Times ran two stories on the Japanese carry trade, painting a seemingly contradictory picture.  The first article profiled the rise in the number of retail forex accounts in Japan, projected to reach 1 million by year-end.  More amazing is the fact that many of these traders are actually quite sophisticated, taking long and short positions in multiple currencies, though of course the most popular bet remains the carry trade, which involves going short the Yen and long a higher-yielding currency.  Meanwhile, as the second article expounded, the Yen carry trade is under pressure, having appreciated nearly 5% against the US Dollar, Euro and Australian Dollar.  The cause is certainly volatility in global capital markets, precipitated by what has been termed a "credit crunch," itself caused by the slump in housing prices. The hoard of Japanese retail investors may have to reverse their positions…

Read More: Pressure grows on yen carry trades and Forex Lures Japanese Investors

As expected, the Bank of Japan left its benchmark interest rate unchanged at its latest meeting.  The current rate of .5% remains the lowest in the industrialized world and thus will continue to fuel the Japanese carry trade.  The Bank fended off the criticism of several European Ministers, wary of the Yen’s continued appreciation against the Euro, including a 5% increase in the last month alone. The EU has insisted that Japan should hike rates immediately both to avoid global economic imbalances and to prevent its own economy from overheating.  Japan defended its decision by pointing to certain small business indicators, which suggest the sector is still underperforming.  Carry traders, rest easy. Bloomberg News reports:

“The Bank of Japan will probably need to put off a hike at least until December to nail down its assessment of global growth as well as the performance of small companies,” said Masaaki Kanno, a former central bank official

Read More: Bank of Japan Votes 8-1 to Keep Key Rate at 0.5%

Japan’s Central Bank now controls over $950 Billion in foreign exchange reserves, second only to those of China.  While Japan is not accumulating significant new reserves, its existing reserves have appreciated in value due to the Euro’s recent ascent.  Analysts are keeping a close eye on the reserves of both countries, which represent close to 50% of the world’s foreign exchange reserves.  In addition, analysts will be watching China, which may take a cue from Japan and diversify some of its reserves into Euro-denominated assets in order to offset the effect of the declining Dollar.  AFX News Limited reports:

Japan’s reserves are closely watched for evidence of how the country is managing its foreign currency holdings. Its actions are seen as having a significant impact on exchange rates and bond markets around the world, particularly the US government bond market.

Read More: Japan’s forex reserves rise to record

The Japanese Yen is finally appreciating, though how long the upward streak will last is anyone’s guess.  These days, the Yen rises and falls on the whims of carry traders.  However, the enemy of the carry trade is volatility and the Fed’s lowering of US interest rates injected enough uncertainty into the markets to send carry traders slowly towards the exit.  As a result, currencies such as the Australian Dollar and New Zealand Kiwi, long popular with in carry trading circles, were quickly dumped as traders bought Yen to cover their positions. Whether the Yen can sustain its momentum depends primarily on the Central Bank of Japan. Bloomberg News reports:

Carry trades utilizing the New Zealand dollar lost 1.9 percent today, according to data compiled by Bloomberg, after gaining 2.3 percent so far this week as the Federal Reserve reduced the U.S. rate a half percentage point to 4.75 percent.

Read More: New Zealand Dollar Drops as Japanese Investors Return to Yen

The US dollar and euro did very well on Thursday, while the yen dropped in comparison. Investors, temporarily confident about the US mortgage crisis, have returned to riskier, higher yielding ventures. So, while Asian and European stocks are going strong, the yen will suffer until the next scare. Reuters reports:

Eyes are now turning to the European Central Bank’s interest rate decision. Expectations of a rate hike from the ECB have diminished since a credit market squeeze that has forced the bank to inject liquidity into the banking system. Most analysts now expect rates to be kept on hold at 4 percent.

Read more: Yen slips as risk appetite edges back

Credit problems in the US have been the source of much turmoil throughout the global markets in the past few months. Tuesday was good for the US dollar, which held strong against both the yen and the euro. However, forthcoming economic reports from the US may or may not tip the scales. According to Reuters:

"The panic is almost over, but the market has lost its direction and is waiting for more news, especially any good news," said Kikuko Takeda, a currency strategist at Bank of Tokyo-Mitsubishi UFJ.

Read more: Dollar drifts as U.S. data awaited for direction

Investors, confident that the US mortgage situation could be weathered, pulled money out of the yen on Wednesday and put it back into risky carry trades. However, things did not look so promising for the US on Thursday. As a result, the yen was once again strengthened by nervous investors. Reuters reports:

The yen brushed off a rebound in European and Asian stocks and climbed after British newspaper The Times reported that the co-head of RBS Greenwich Capital’s collateralised debt obligations unit had left the bank along with six colleagues.

Read more: Yen recovers as spotlight returns to subprime fallout

While the US had a rough day yesterday, European stocks performed well enough to tempt investors away from the yen. Though a stable currency, the yen is a low-yielding investment and traders are ready to try their hand at a riskier venture with European stocks. There is no word yet on how this may affect Wall Street. According to Forbes:

This has pushed the yen down as investors make tentative steps back to engaging in the risky carry trade - where investors sell low-yielding currencies such as the yen to buy higher-yielding ones elsewhere. With no US data due this afternoon, how equities fare on Wall Street is likely to determine whether the rise in risk appetite can be sustained.

Read more: Yen falls back as stable European stocks prompt revival in risk appetite

Once again, fear of US mortgage problems has led investors back to arms of the reliable yen. A low-yield, low-risk currency, the Japanese yen has become a safe haven for skittish traders in recent weeks. Investors are right to be concerned, as the US housing market hasn’t been in this kind of shape in two decades. Reuters reports:

The yen extended gains against the dollar after a measure of U.S. home prices reflected the biggest year-on-year decline in the second quarter since 1987.

Read more: Yen rises as credit fears swirl

Following a tumultuous period that stemmed from mortgage problems in the US, the global markets are finally calming down. While this is good news for most, the Japanese yen is weakening as a result. Why the change? Investors are feeling more confident about high-yielding ventures once again, leading them to pull out of the yen and continue with high-risk carry trading. Reuters reports:

While confidence in global credit markets has by no means been fully restored and fears remain that short-term liquidity could dry up, investors across a range of asset classes felt bold enough to shun safe-havens and seek higher returns.

Read more: Yen lower as calm returns to markets

Despite the effects of US subprime mortgage troubles on the rest of the world, investors have scaled back risky ventures and increased the value of both dollar and yen. While this result may be inadvertent, it is much appreciated by those who have lost major funds in the stock market recently. The future doesn’t look any brighter for US mortgage, either. According to Hemscott:

Housing starts sank 6.1 pct in July to a 1.381 million unit annual rate, the lowest since January, while building permits — a more forward-looking indicator — fell 2.8 pct to a 1.373 million rate, the lowest since October of 1996.

Read more: Dollar and yen continue higher amid flight to safety

With the United States’ mortgage problems trickling into Europe, many investors have been thrown into a panic. However, the Japanese have reduced their high-risk investments, moving funds back into the reliable yen. As a result, the yen is fairing much better than other currencies. Those who have suffered from this sudden scramble include New Zealand and Australia. According to Forbes:

The increasing pressures in credit markets — with the European Central
Bank yesterday injecting 95 bln eur to boost liquidity in euro money markets — came on fears that the US subprime mortgage troubles may be spreading to Europe. Several banks admitted exposure to subprime markets, and BNP Paribas froze three asset-backed funds. This caused investors to panic and cut their exposure to carry trades — the use of low-yielding currencies to fund higher-yielding investments

Read more: Yen still strong on risk aversion

Last week witnessed a sudden unwinding in the yen carry trade, as a global market downturn affected investor sentiment towards risk. Volatility is the only market force that could seriously contend at collapsing the carry trade, and last week produced significant volatility. All of the world’s majors fell against the Yen, namely the New Zealand Kiwi, which fell by 7.5%. The kiwi, you may recall, has been one of the main currencies on the other end of the carry trade, due to its high interest rates. However, analysts are reluctant to proclaim an outright end to the popular carry trade, preferring to wait and see how volatile the world’s capital markets appear in
the coming weeks. The Financial Times reports:

The wave of risk reduction also prompted investors to take profits in the Australian and New Zealand dollars, which have surged this year from central bank credit tightening or expectations of more tightening to come.

Read More: Yen hits 3-month high versus euro

The Japanese Yen has slid to a record low against the Euro, with no obvious end in sight to the wounded currency’s multi-year decline. The basis for the continued yen weakness is the expectation that Japan will hold interest rates at current levels until the end of the summer, a notion that was reinforced by the Bank of Japan yesterday. As a result, carry traders, who categorically fear volatility, can feel confident that a continued low interest rate environment will support the viability of the Yen carry trade in the short term. However, there are a few risks in the horizon, namely that Japan’s economy and stock market are outperforming and could prompt a series of rate hikes in the fall and lure Japanese capital back to Japan. DailyFX reports:

The rallies are becoming overextended of course and the risk of some action by the Japanese government is increasing, but until carry traders have a reason to bail, they probably will not.

Read More: Japanese Yen Continues to Fall

This week, the President of the Central Bank of Japan essentially ruled out the possibility of a near-term rate hike, which was exactly the kind of reassuring news forex carry traders wanted to hear. As a result, the Yen quickly dropped to record lows against the Euro, British Pound and Australian Dollar, as well to a four-year low against the USD.  Surprisingly, the Swiss Franc, would seem an excellent candidate to fund the carry trade, is also surging. Now that any near-term volatility-which is the bane of carry traders-has been removed, the carry trade is likely to thrive. High-yielding currencies, such as the New Zealand Kiwi, will likely attract continued attention from speculators. At this point, it seems the only thing that could possibly slow the carry trade is a Japanese rate hike, or the mere threat of one.

Read More: Carry trades hit yen but Swiss franc surges

It has been mooted on several currency forums, including here, that volatility is the enemy of the carry trade.  For this reason, many analysts predicted that last week’s bond market collapse would send Japanese capital-which had been parked in the US-back to Japan, thus triggering a rapid appreciation in the Japanese Yen. But nothing of the sort materialized. The Yen was virtually unaffected by the week’s turmoil, as Japanese investors continue to invest in countries that offer high-yielding investments, such as New Zealand, which surprisingly raised interest rates to 8%.  A Japanese senior official supported this notion, reports The Financial Times:

“The size of any carry trades that would unwind is relatively small compared to the entire foreign-exchange market.”

Read More: Japan official sees no end to carry trade

The Japanese Yen continues to slide against the both USD and the Euro, despite Japan’s purportedly strong economy.  The release of dovish inflation data was music to the ears of Japan’s Central Bank, which seems intent on leaving interest rates frozen at .5% for as long as Japan’s economy will support it.  Meanwhile, volatility is way below its historical average, and traders remain committed to the carry trade. In addition, currency futures prices indicate that traders believe the Yen will fall further in the near-term. Bloomberg News reports:

“In times of low volatility and plenty of cash, people tend to put on carry trades,” said Meg Browne, a senior currency strategist.

Read More: Yen May Reach Record Low Versus Euro as Prices Forecast to Fall

This week, the US Congress conducted a hearing on “Currency Manipulation And Its Effects On American Businesses And Workers,” for which it invited numerous experts to weigh in on undervalued currencies.  Among those who testified was General Motor’s Chief Economist, who discussed Japan’s purported policy of holding down the Yen, within the context of the auto industry.  He argued that by maintaining an already large and growing reserve of foreign exchange, by purchasing US assets through quasi-governmental institutions, and by threatening to intervene in forex markets if the Yen appreciated, Japan has successfully prevented the Yen from rising over the last few years, despite such a course being justified by economic fundamentals.

“Japan’s policies provided anywhere from a $2,000 to $14,000 cash windfall for each of the 2.2 million vehicles Japan’s automakers exported to the U.S. in 2006.”

Read More: GM chief economist testifies against alleged Japanese currency manipulation

“Pick your battles,” seems to be the mantra that Jean-Claude Trichet, President of the European Central Bank (“ECB”), is currently living by.  While the Euro is slowly inching closer to record levels against the USD, Trichet has largely been content to focus his energy on a different nagging currency: the Japanese Yen.  Trichet has invoked the phrase “two-way risks” in cautioning investors to beware the enormous potential upside of the Yen.  Trichet realizes that the Japan-EU interest rate differential, manifested through the carry trade, is responsible for the diverging Euro-Yen exchange rate.  Ultimately, it remains unclear whether the EU will continue to limit itself to rhetoric in the battle to hold down the Euro, or whether it will use more heavy-handed tactics.  Forbes reports:

“We believe the Japanese economy is on a sustainable path and that foreign exchange rates should reflect that,” Trichet said.

Read More: ECB’s Trichet says currency markets should be
aware of ‘two-way risks’

Several months ago, I wrote a commentary piece on why it was wise for forex traders to abandon in the carry trade in favor of more innovative trading strategies.  I may have to eat my words, since interest in the carry trade hasn’t waned as expected, but rather has grown.  Economic data support the notion that the carry trade is almost fully responsible for the plight of the Yen, as Japan is experiencing a net outflow of capital on paper.  Anecdotal evidence is also abounding; dozens of forex firms have sprung in Japan to help retail investors take advantage of the declining Yen.  Meanwhile, when probed on the issue, the Chief Economist of the International Monetary Fund (“IMF”) indicated that he does not think it necessary for Japan to intervene in forex markets and prop up the Yen.  Dow Jones reports:

“The weakness of the yen in particular suggests that the forthcoming G7 meeting is having little impact on market psychology and focus is instead on declining volatilities, which has served to attract market flows back into carry trades.”

Read More: Interest In Carry Trades Likely To Intensify

To no one’s surprise, the Bank of Japan has announced that it would maintain Japanese interest rates at the current level of .25%.  Carry traders seized upon the opportunity to continue borrowing Yen at near-record lows, and selling the Japanese currency in favor of higher-yielding alternatives.  In fact, the news was met with such gusto that the Euro was almost immediately propelled to an all-time high against the Yen, which continues to plumb the depths of forex disfavor.  At this point, analysts and economists are feeling fairly certain that Japanese interest rates will remain at current levels in the near-term, a sentiment which supports the viability of the carry trade. Forbes reports:

One analyst commented: “with BoJ expectations stable, currency market volatility subsiding and risk aversion abating, carry trades are recovering, keeping the yen under pressure.” He sees no immediate catalyst for a yen recovery.

Read More: Euro hits record high against yen as carry trades continue

The Yen is rising once again, as another set of investors unwind their carry trade positions. No, it wasn’t the threat of higher borrowing costs, via a hike in Japanese interest rates, that spooked investors. Rather, it was general volatility in forex markets that jolted investors to re-assess their short positions in the Yen. Volatility is anathema to carry traders, as shorting a currency is similar to shorting a stock. Once any security that one has shorted begins to rise, short sellers are pressured to ‘buy to cover’ which only sends the currency higher and triggers further buying to cover. This phenomenon is known as a ‘short squeeze’ and seems to affect the Yen every time volatility surfaces. The Financial Times reports:

Analysts said the resulting rise in risk aversion had led investors to exit carry trades, in which the purchase of riskier high-yielding assets is funded by selling low-yielding currencies such as the yen.

Read More: Investors exit from carry trades

The Yen has already dropped to a 3-week low against the world’s major currencies as forex traders move to put the crash in global capital markets behind them. Volatility, the factor that many analysts consider the bane of the carry trade, is also declining. Tomorrow, the Bank of Japan is expected to announce that interest rates will be left unchanged, and probably will remain at current levels until the end of the year. This announcement should further put the minds of traders at ease. All in all, it looks like the Yen will resume its gradual downward path that it was pursuing prior to the bounce it received from the crash. Forbes reports:

Recently, sharp falls on equity markets…had sparked some unwinding of carry trades. Investors have begun the week by resuming them following firm US inflation data last week and solid gains in equity markets.

Read More: Yen continues to edge lower as carry trades resume

Last week, the Japanese Yen reached levels of volatility not seen in years, as a sell-off in Asian capital markets spread to forex markets, and nervous investors began to unwind carry trade positions in the Japanese Yen. The Yen spiked almost 3% in an instant, and many analysts feared a Yen appreciation on a scale comparable to 1998, when the Yen appreciated by almost 15% in two days. This time around, the Yen failed to maintain its upward momentum, and soothed investors began to rebuild their short positions in the Yen, driving it back towards its earlier value. The Financial Times reports:

Currency flow data showed that institutional investors had amassed massive short yen positions in the last six months at an average rate of about Y119.70 against the dollar. At the current rate, they would take until April 30 to be squared.

Read More: Calm returns to currencies after a volatile week

Global capital markets picked up today right where they left off last week, sliding downward with no end in sight. A general aversion to risk is driving the markets, as investors pile out of equities and into bonds. Also benefiting from the global sell-off is the Japanese Yen, as nervous investors move to cover their carry positions built up over the last year by buying Yen. It remains to be seen whether the Yen will continue its upward move after the current frenzy subsides, since it may just as well be a temporary increase in volatility that is driving the Yen rather than a long-term correction. Once the markets cool, it is possible that complacent investors will move once again to build up their Yen short positions. Forbes reports:

Now, locked in a reverse vicious cycle, the rapid unwinding of carry trades has applied upward pressure on the yen, compelling other investors to reduce positions on carry trades and enticing speculative currency traders to buy yen.

Read More: Investors Adjust to the Yen’s Surge

Yesterday, the collapse which roiled global financial markets spread to forex markets, causing the Yen to loosen from its moorings and sending the currency upward against most of the world’s major currencies, including a 2% rise against the USD. While the Yen has already given back some of these gains, many analysts are already speculating that this jolt some life into the Yen and put an end to the carry trade which has sent the Yen to record lows. Ultimately, it is volatility that will lift the Yen, and Yen bulls are surely hoping for another week like this one. CBS Marketwatch reports:

“One of the things that carry trade relies on is relative low levels of volatility. Clearly the most recent catalyst has been the Chinese market meltdown triggering a meltdown in other emerging markets and basically a shift out of riskier assets into less risky assets.”

Read More: Carry trade unwinding roils currency markets

Before I attempt to answer the following question, let’s examine where the Japanese Yen is today and more importantly, how it got there. The story begins around the establishment of the second Bretton-Woods agreement, which de-linked the USD from gold, and ushered in the modern era of freely floating currencies. In the 30 years that have elapsed since this period began, the Yen has never been less valuable. In fact, in trade-weighted terms, the Japanese Yen is at an all-time low!

The decline began in 1995, touched off by a nagging recession and the accompanying easy monetary policy, in which Japanese real interest rates were effectively negative. The decline seems to have accelerated over the past five years, due to the proliferation of the carry trade. In this type of trade, investors borrow Japanese Yen at a low interest rate, and sell the Yen for a currency which is supported by higher interest rates. The profit, known as carry, is the spread between the two rates. Hedge funds have piled into the carry trade, driving the Yen to lower and lower depths.

Politicians, relying on economists, have begun to clamor for reform. For a while, trade representatives and politicians insisted Japan was intervening on behalf of the Yen, which was ostensibly keeping the Yen grounded. They have since retreated from this position and embraced the carry trade theory as being responsible. Regardless of the causes, everyone agrees that the Yen’s undervaluation is not only destabilizing, but is economically inefficient. After all, Japan is home to the world’s largest trade surplus, and its economy is growing at an annualized rate of almost 5%!

So why doesn’t Japan give in and raise rates? The answer, it turns out, may not even matter. Traders have speculated that it require a rise of 200 basis points in Japanese interest rates for the carry trade to lose its appeal, an event which is extremely unlikely to occur by the end of 2007. Instead, a little bit of volatility in forex markets might go a long way in coaxing the currency upward. The Economist has drawn an analogy of the current situation to 1998, when the Russian default made hedge funds nervous, and they unwound their carry positions in the Yen. The result was a rapid 15% appreciation in the Yen.

The Japanese Yen had a strong opportunity to reverse its long-term slide against the USD this week after the release of economic data, which indicated the Japanese economy is now expanding at an annualized rate of 4.8%. This is the fastest growth recorded by Japan in almost a decade, increasing the likelihood that the Central Bank of Japan will finally raise rates at its meeting next week, and induce an end in the carry trade, which has prevented the Yen from rising in accordance with what analysts believe are strong economic fundamentals. Unfortunately, the Yen largely failed to move against the USD, which means it will probably take more than a rate hike to drive the Yen out of its entrenched pit. FxStreet reports:

Read More: Dollar takes breather vs yen after sell-off

In response to an outpouring of anger and frustration by EU officials that the subject of the Japanese Yen be discussed at this week’s G7 meeting, US Treasury Secretary Henry Paulson has publicly stated that he does not believe there is anything to talk about. For two years, the Yen has remained the world’s most conspicuously undervalued currency. American trade lobbyists and EU trade officials insist it is because of the perceived threat of intervention by the Central Bank of Japan should the currency ever appreciate. However, most traders and financial economists would tell you that the cause is simple: low Japanese interest rates have resulted in carry trading, which by definition puts downward pressure on the Yen. It is on this side of the fence that Paulson seems to be standing. Reuters reports:

“I think the big point I made at the hearing yesterday was that — in counter-distinction to China — the Japanese have a currency that is traded in an open and competitive marketplace based upon economic fundamentals,” Paulson said.

Read More: Paulson satisfied yen value set by markets

The Yen is by far the weakest major currency in the world, having recently touched an all-time low against the Euro and a four-year low against the USD, despite strong economic fundamentals and a positive current account balance. It has been reported exhaustively that the cause of the Yen weakness are low interest rates, which has spurred investors to borrow cheaply in Yen and invest in higher-yielding currencies. Even domestic Japanese investors are exerting downward pressure on the Yen by shifting funds abroad in the search for yield. The lower the Yen drifts-in complete defiance of economic fundamentals-the greater the risk a sudden reversal poses to global forex markets; at this point, it could be devastating. The Wall Street Journal reports:

The extent of this kind of trading is notoriously difficult to measure. But, according to a Jan. 26 report by Barclays Capital, the magnitude of yen-funded carry trades “is reaching scary levels” not seen since 1998.

Read More: As Yen Slides, Fears Mount Of a Shakeout

While its economy expands, its currency sinks. This is the conundrum that currently defines Japan. At this point, it is evident that the weakness in the Japanese Yen can be almost solely attributed to low interest rates, which have spurred countless traders to borrow in yen and invest in higher-yielding currencies, as part of a carry-trade strategy. It seems Japan is either unsure that its economy can withstand a rate hike-which would elevate its currency-or simply unwilling to take such a chance when a cheap currency is spurring export growth. In any event, the G7 will officially take up the issue at a conference next month in response to rising foreign criticism that Japan is artificially holding the Yen down. The Financial Times reports:

“European” concerns over yen weakness might may actually reflect French and Italian concerns and with Angela Merkel, German chancellor, playing down worries over euro strength, the “G7 factor” may not last.

Read More: G7 speculation fuels volatile yen

In a move that jived with investor expectations, the Bank of Japan voted last week to maintain interest rates at current levels, which leaves the benchmark lending rate of .25% the lowest in the industrialized world. While Japan has definitively emerged from its decade-long recession, policy makers apparently are not convinced that the economy is in strong enough shape to support a rate hike. Besides, the Central Bank is certainly enjoying downward pressure on the Japanese Yen in forex markets, since a cheap Yen makes for competitive exports, which are the cornerstone of Japan’s economy. The upshot is that the carry trade, in which investors borrow in Yen and invest in securities denominated in higher-yielding currencies, will remain a viable option for the foreseeable future. Reuters reports:

Even if the BOJ had lifted rates, many analysts believed a move would provide little relief to the yen because short-term Japanese interest rates remain so much lower than those of other currencies and the BOJ has pledged to lift rates only gradually.

Read More: Yen hits 13-month low, BOJ keeps rates on hold

2006 was a turbulent year, as many of the world’s major currencies fell out of synch, rising or falling by as much as 15%. Nonetheless, implied volatility (which can be calculated indirectly from currency options), fell to multi-year lows. Analysts have attributed this phenomenon to improved communication of Central Banks, a significant increase in forex trading volumes and a relatively stable global economy. As a result, the carry trade has defied the predictions of experts (including your correspondent) by remaining popular. Investors continue to borrow in Yen and Swiss Francs (with interest rates of .25% and 2% respectively) and invest in higher-yielding currencies. If the current monetary framework remains in place, this should be a profitably strategy. However, fortunes are lost as quickly as they are made, reports Reuters:

The flip side is that any gains can be quickly eroded by a rally in the funding currency — something which is less likely to happen in markets where volatility is low.

Read More: Low FX volatility, carry trades here to stay

Last week, a well-respected Japanese economist publicly urged Asian nations to take joint action in accepting the fall of the USD against their respective currencies. He encouraged them to fight the temptation to intervene in forex markets, because such could potentially cause massive instability. Most Asian nations would lose on two fronts of the USD continued to decline; their economies would suffer due to less competitive exports, and their USD-denominated reserves would become relatively less valuable. However, it seems that most of these countries could withstand a 20% decline in the USD, despite any negative short term fallout. The New York Times reports:

“It would be very difficult to achieve such coordination. However, we have seen Asia coordinate in some areas where they normally compete, such as when India and China bid for foreign energy assets.”

Read More: Leading Asian Economist Urges Joint Action on Dollar

According to a recent report, the Bank of Japan may raise interest rates at least once in the coming months. As Japan’s economy continues to surge ahead, the Central Bank is finding it difficult to justify its decade-long policy of easy money. Currency traders are watching this story closely, perhaps more closely than the monetary policy of any other country because it is Japan’s interest rate environment which is responsible for the record low valuation of the Yen. As long as interest rates remain at current levels, the carry trade (in which investors sell Yen and buy other currencies) will remain viable and continue to depress the Yen. AFX News reports:

It will take a definite signal that Japanese interest rates are set to rise further or that US interest rates are more likely to be cut than hiked next year, for the carry trade trend to dissipate, analysts said.

Read More: Yen recovers slightly…

The Yen is rapidly approaching all-time lows (in real terms) against the world’s major currencies, and many analysts think they understand what’s behind this phenomenon: the carry trade. In a carry-trade strategy, investors will sell a currency that offers a low interest rate (with proportionately low borrowing costs) and will use the proceeds to buy a different currency that is supported by higher interest rates, effectively earning a return equal to the difference in rates. In the case of Japan, negative real interest rates have prompted many investors to short the Yen in favor of higher-yielding currencies, driving the currency to its current depths. However, analysts argue that a slight uptick in the Yen could drive many investors to quickly unload their positions (approximately $80 Billion outstanding), causing the Yen to appreciate. The Financial Times reports:

The potential of the carry trade as a source of future exchange rate volatility has brought back memories of October 1998 when the yen collapsed against the dollar as hedge funds unwound carry trades in response to the Russian financial crisis.

Read More: Analysts fear sudden rise in yen’s value

Due primarily to soaring commodity prices and a strong economy, Russia has amassed the third largest stock of foreign exchange reserves in the world, now totaling $268 Billion. As a result, when Russia announced that it would begin to hold some of its reserves in Yen, forex traders stopped to listen. Previously, Russia’s reserves were denominated in USD and Euro assets. As the Yen is arguably the most undervalued currency in the world, it makes sense from both a financial and risk management standpoint. The Financial Times reports:

While the news was positive for the yen at the margin, it would be wise for investors not to overreact, given the global context in which central banks have been consistently reducing the share of yen in their foreign exchange holdings.

Read More: Russian reserve switch boosts yen

This weekend, North Korea confirmed that it had indeed conducted nuclear weapons testing. Forex markets responded by pummeling the Japanese Yen, for no particular reason other than the proximity of Japan to North Korea. It is clear that the North Korean diplomatic crisis will not exert any effect, positive or negative, on the Japanese economy. Nonetheless, as is often the case, the markets needed something to trade on, and figured a political crisis would provide the impetus to bring the Japanese Yen lower against the USD. Forex TV reports:

“Being anywhere near the Korean peninsula this weekend is not something the foreign exchange market relishes - the yen is underperforming in that situation.”

Read More: Yen continues fall vs dollar on NKorea concerns

While most of the ire of Central Banks is currently focused on China, it seems Japan may also deserve some of the attention. Despite the current economic boom and concomitant current account surplus in Japan, the Japanese Yen continues to lose value against the world’s major currencies, a phenomenon that has baffled analysts. In fact, the Yen is currently nearing an all-time low in trade-weighted terms, and recently touched an all-time high against the Euro. Some have speculated that fear that the Bank of Japan will intervene if the Yen rises too sharply has depressed the Yen. Others believe that it is Japan’s low interest rates which have sustained the always-popular carry trade and driven many to sell the Yen in favor of higher-yielding currencies. Still other experts think it is Japan’s ever-growing forex reserves which keep the currency in check. The Economist reports:

Last week was the 21st birthday of the G7’s Plaza Accord, which triggered a huge rise in the yen. The yen is much more undervalued today than it was then.

Read More: Yen and yang

While many topics were mooted at last weekend’s G7 summit, there was only one subjected that forex traders cared about: whether the world’s developed nations would publicly urge Japan to lift the value of the Yen. Unfortunately, the only reference to the Japanese Yen at the meeting was a comment that suggested the Yen was undervalued and should more closely reflect economic fundamentals. Whether this will actually translate into a stronger Yen remains to be seen. However, most analysts do not expect Japan will take any steps to appreciate the Yen unless the country is pressured to do so. Reuters reports:

Some traders were also disappointed that the G7 dropped the annex from the April meeting’s statement calling explicitly for Asian currencies to appreciate.

Read More: Yen slides back towards all-time lows vs euro

The G7 nations have decided to make a late addition to the agenda for their meeting in Singapore later this month: the weakness of the Japanese Yen. The Yen managed to stay below the radar for years, but due to growing trade imbalances, leaders from other industrialized nations have begun to complain that Japan’s Central Bank is artificially depressing the Yen to give Japanese exporters an unfair advantage. Especially now that Japan’s economy seems to have definitely emerged from its recessionary and deflationary period, it no longer requires a cheap Yen. This development could have important ramifications in forex markets, if G7 leaders decide to sanction Japan. Forbes reports:

“The G7 is no longer willing to allow the yen weakness to continue as Japan does not require a weak currency given the growth/inflation outlook.”

Read More: Yen surges on confirmation G7 will discuss currency

For the first time, officials from China’s Central Bank will meet publicly with their counterparts in Japan, a nation that knows a thing or two about currency appreciation. Over 20 years ago, the world’s industrialized nations signed the Plaza Accord Agreement, which laid out a plan for devaluation of the USD against the Japanese Yen. The purpose of the agreement was to help the US stem its current account deficit and simultaneously emerge from an economic recession. [Note the similar circumstances which currently surround the attempt by the US to depreciate the USD against the Yuan.] Anyway, the result of the agreement was a Japanese recession, and ultimately, an asset price bubble which continues to plague Japan to this day. Chinese officials hope to learn from Japan’s travails and avert a similar economic implosion.

Read More: China seeks to learn from mistakes of 1985 Plaza Accord

Two weeks ago, I reported that the carry trade would soon come to an end, and traders would have to develop alternative strategies in order to continue profiting in forex markets. While interest rate differentials still remain sizable, it seems traders are finally beginning to take heed of this message by building future rate changes into their models. Japanese interest rates remain effectively negative, but a spate of recent data indicated that Japan’s economy has recovered from its multi-year recession. The Yen has sunk to a 20 year low in real terms, and the only place it can go is up. Those who continue to rest on carry trading risk getting burned. The Financial Times reports:

[The data] did not alter the prognosis for Japanese rates, which are still expected to remain unchanged when the BoJ meets this week – but it derailed the carry trade, as attempts to short the yen were by this point wildly overdone.

Read More: The Short View: Risk appetite

The Yen continues to take a beating from currency traders, who seem intent on wringing profits out of the Japanese currency before the Central Bank raises interest rates. Two weeks ago, I reported that the carry trade would soon lose steam as central banks around the world hike rates and interest rate differentials begin to narrow. However, Japan’s Central Bank has assured investors that any monetary tightening will be implemented gradually, in order to avoid a rapid Yen appreciation. As a result, investors seem confident that the carry trade remains a safe bet in the short term. If the Yen contineus to depreciate, and real interest rates remain negative, such investors will look pretty savvy. Bloomberg News reports:

Investors are using the so-called carry trade to borrow yen at rates barely above zero percent and use the money to speculate in the markets where central bank rates are as much as 14.5 percentage points higher.

Read More: Yen Slumps Most in Nine Months as Interest-Rate Trades Resume

This week, Japanese automakers reported strong earnings for the latest quarter, and American trade groups are furious. If you remember, American automakers have been complaining for the better part of this year that the Japanese government is depressing the value of the Yen in order to make Japanese exports more competitive. When confronted with the fact that the Bank of Japan has not officially intervened on behalf of the Yen since 2004, the automakers respond that the government continues to threaten intervention in the event that the Yen actually appreciates. This is tantamount to currency manipulation, they argue, because traders are reluctant to bid up the value of the Yen lest the government actually intervene to force it back down. Reuters reports:

“Every time the yen starts to move in a substantial way, ‘Japan Inc.’ and the Japanese finance minister roll out thundering noises” discouraging currency traders from betting on a stronger yen.

Read More: US automakers say Japan profits fueled by cheap yen

Earlier today, China announced that the minimum amount that banks must place with the central bank will be increased by 0.5% beginning August 15. This reserve requirement increase caused the yen to reach its one-week high against the USD. It came as a disappointment to Washington however that there was no further discussion of yuan flexibility, but it is likely that this debate will heat up in the coming weeks and months. Forbes reports:

Bank of New York currency analyst Neil Mellor noted that Ba Shusong, an influential government economist said today that China needs to widen the yuan’s trading band to help control excess liquidity.

A further widening of the trading band ‘could easily come within the next few weeks,’ Mellor reckoned.

Read more: Yen gains against dollar as China raises reserve requirement

Tomorrow, the Bank of Japan will meet, and it is expected that they will raise the interest rate in Japan to 0.25%. Such an occurence would mark the first time in five years that the interest rate was above zero. Yesterday, the US dollar rose to a six-day high of 115.73 yen in response to the expected rate hike. According to Life Style Extra:

‘The recent spike higher in dollar/yen provides a new opportunity for playing future yen strength as interest rate differentials narrow, the economy remains strong and the current account surplus provides a happy contrast to structural deficiencies in the US,’ [Daragh Maher of CALYON] said.

Read more: Yen rises ahead of BoJ meeting tomorrow

This year, the US current account deficit is projected to reach $800 Billion, an astounding 7% of GDP. If current trends continue, the deficit will jump to 13% of GDP by the end of the decade. Moreover, this year will probably mark the first ever that the net US return on foreign investment will be less than the money earned by foreigners on US investments. For this trend to be reversed will require a massive depreciation in the value of the USD. Unfortunately the US is tightening monetary policy at a faster rate than the rest of the developed world, which renders such a reversal unlikely. The Economist reports:

Not only is the yen relatively weak in nominal terms, but falling prices in Japan have made it even more competitive.

Read More: The Yen also Rises

The most recent data on Japanese capital flows paints a picture of increasing repatriation of Japanese capital. In other words, Japanese people and businesses are divesting from overseas assets and parking their money in Japanese securities. Analysts have offered a couple explanations for this trend. First, yields on Japanese bonds have been growing as the Central Bank prepares to lift interest rates, and Japanese equities are approaching valuations left unseen for years. Perhaps, notoriously conservative Japanese investors are growing more confident in the strength of domestic asset markets. Second, and equally plausible, is that Japanese companies are repatriating profits earned overseas for tax purposes. Either way, the Yen will benefit. The Financial Times reports:

Data released on Friday by Japan’s Ministry of Finance revealed that Japanese investors sold a net Y1,480bn of foreign assets in the week to March 17, a six-fold increase on the week before.

Read More: Yen rallies on year-end repatriation flows

This week will end the second consecutive year in which Japan’s Ministry of Finance has abstained from intervening in forex markets. This is noteworthy, perhaps, in light of the fact that the Yen is poised to begin appreciating, on the heels of Japanese rate hikes. Most analysts do not expect the Bank of Japan to intervene if the Yen does begin to rise, because Japan’s economy appears to be in good shape. Several years ago, when the Bank of Japan spent over $300 Billion to prevent the Yen from rising, Japan’s economy was still fragile and forex intervention could be more easily justified. The Standard reports:

Japanese officials say there is no change in their standard refrain that currencies should stay in line with economic fundamentals, and movements should not become too volatile.

Read More: Tokyo tipped to let yen rise

The consensus among economists is that Japan has clearly emerged from a decade-long recession, which is a conclusion predicated on a bevy of economic data. The Bank of Japan is now in the unenviable position of having to raise interest rates to head off possible inflation, without shocking the economy back into recession. In a recent poll, a majority of economists indicated their belief that the rate hikes will be effected before the end of the year. While the Yen may not derive direct support from the rate hikes, it will likely benefit from an inevitable decline in carry trades, in which currency traders borrow Japanese Yen to finance purchases of other currencies. Reuters reports:

“Japanese rates are still going to remain extremely low - below 2 percent next year — and it will still be the lowest, notwithstanding the Swiss franc.”

Read More: BoJ change to ripple, not rock, through markets

In the last few months, a whole host of economic indicators have confirmed both that the Japanese economy is on solid footing and that the era of deflation has finally passed. Accordingly, many economists and analysts predicted that Japan would soon end its ultra loose monetary policy where real interest rates where kept below zero. In the last few days, however, currency traders have been working overtime to rid their models lofty rate hike expectations. The cause of the uncertainty has been the Bank of Japan, itself, which has insisted that it will continue to hold short term interest rates to below .1%, and long term rates to a proportionately low level. The Financial Times reports:

Reports suggested the BoJ will continue to pump liquidity into the economy by buying Y1,200bn worth of government bonds a month to keep long-term rates capped. “This would help…reduce market turmoil, including speculative yen buying.”

Read More: Yen falls on dovish rate talk

According to a variety of economic indicators, Japan is now the fastest growing economy in the G8 Industrialized countries. Further, it seems Japan has definitively succeeded in ending a decade-long deflationary spiral, during which its nominal GDP declined. Japanese economists have hinted that the Bank of Japan may soon end its ultra-loose monetary policy. This move, which will take the form of higher interest rates, has even received the support of Japanese politicians, who previously seemed ambivalent. While the rate hikes will not occur for a couple of months, currency traders are already beginning to buy Yen based on the prospect of a narrowing interest rate differential between Japan and the rest of the developed world.

Read More: Policy hope propels yen’s rally

A few weeks ago, the Bank of Japan released official data that indicated it had not intervened in forex markets in over 18 months. It was expected that this data would exonerate Japan from the accusations of American auto makers, who insisted Japan was artificially holding down the value of the Yen. Sure enough, representatives from these auto makers have backed away from their claims of forex intervention, arguing instead that the bank’s threat of intervention is tantamount to actual intervention. It has also begun to shift some of its attention to Korea, where the Central Bank routinely intervenes to hold down the value of the Won. United Press International reports:

Despite strong economic growth, over the past five years Japan’s currency has been undervalued by as much as 36 percent against the dollar. This means a car imported from Japan has had an unfair subsidized cost advantage over U.S. cars.

Read More: Outside View: U.S. cars need Bush’s help

Earlier this week, Japan released a slew of economic data, all of which underscore the likelihood of future rate hikes by the Bank of Japan. First, Japan announced that annualized GDP growth for Q4 exceeded 5.5%, which exceeded growth in both the US and EU. Further, Japanese prices increased by 1.6% on an annualized basis, which indicates Japan seems to have finally escaped from the throes of deflation. If growth and inflation numbers continue to exceed expectations, you can assume Japan will begin raising rates by the end of this year. Currency traders are already beginning to build models around such interest rate hikes, all of which favor the Yen.

Read More: Yen tumbles on fresh deflation fear

As evidence that Japan has emerged from recession continues to mount, economists and analysts have begun to speculate that the country’s Central Bank will raise rates from their current level of zero. According to the most recent inflation data, Japanese prices have increased for two consecutive months, a feat that had not occurred in nearly a decade. Governors from the Bank of Japan, have themselves hinted that it may be time to stop pumping liquidity into the Japanese economy via an ultra-loose monetary policy. As a result, the consensus is that Japan will begin raising interest rates at the end of this year. Yen bulls have reacted to the prospect of rate hikes with veritable jubilation, arguing that higher interest rates would surely translate into Yen appreciation. The Financial Times reports:

Although the BoJ is not expected to end its zero interest rate policy until next year, any pre-emptive rise in borrowing costs could reduce the use of the yen as a funding currency for the infamous carry trade. This would allow the currency, which most strategists view as undervalued on a fundamental basis, to appreciate.

Read More: Yen climbs on hopes of BOJ policy shift

Currency traders have had veritable months to mull the widening interest rate differential between Japan (where interest rates have remained effectively negative for several years) and the rest of the developed world. Accordingly, many traders have turned to technical analysis in order to gauge sentiment surrounding the Yen. The consensus, which is supported by data, indicates the Yen has been heavily sold short, as institutional and retail investors, alike, have bet against the Japanese currency. While this might suggest the Yen is due to fall, many analysts have reached the opposite conclusion. Basically, many retail investors have leveraged their positions to the degree that any Yen appreciation would force them to quickly buy Yen to cover their positions, resulting in a so-called “short squeeze.” If thousands of traders bought to cover en masse, this would likely feed back into the Yen causing an even larger appreciation. The Financial Times reports:

Trader data released on Friday showed a huge jump in short-yen positions to 43,126 in the week ending January 31, from just 8,839 a week earlier. This would have provided significant fuel for a yen bounce once an initial move higher had been made.

Read More: FX markets focus on fate of yen

According to the most recent financial data, the Central Bank Japan has stayed out of currency markets for 22 consecutive months. If this is indeed true, the implications are potentially far-reaching, as accusations of intervention have reached fever pitch in the US. In the last few weeks, several prominent American manufacturers have publicly insisted that Japan’s Central Bank is helping Japanese exporters by intervening in forex markets to hold down the value of the Yen. However, Japan’s innocence has been borne out by a slew of data, which suggest that the value of the Yen is consistent with economic fundamentals.

Read More: Japan stays out of currency markets in January for record 22nd month+

For several years, real interest rates in Japan have remained effectively negative, allowing those who were creditworthy to borrow enormous sums of money at improbably low rates. It was hoped that the extremely loose monetary policy would stimulate the Japanese economy, by encouraging consumers and businesses to borrow money towards consumption and investment, respectively. While the Japanese economy is finally beginning to show signs of life, and the risk of deflation is waning, Japan’s Central Bank still appears unwilling to lift interest rates. In a recent press conference, representatives from the bank indicated that it would first need to see strong evidence of economic growth and inflation before it would even consider raising interest rates. The news sent a shiver through currency markets, as traders priced in the possibility that interest rates would remain low for a while longer. The Financial Times reports:

Steven Pearson, chief currency strategist at HBOS, saw signs of rising inflation expectations, with the BoJ likely to fall behind the curve. In this environment he saw Japanese retail investors continuing to buy gold, selling yen in the process.

Read More: Yen slides on monetary policy fears

Over the past few months, there has been a back-and-forth between US trade lobbyists (mostly representing US automobile manufacturers) and Japan’s Central Bank. Specifically, US corporations have accused Japan’s Central Bank of repeated intervention in forex markets, designed to hold down the value of the Japanese Yen. The latest chapter in this saga unfolded yesterday, when the CEO of Daimler Chrysler suggested that the US match the efforts of Japan by intervening in forex markets and artificially depress the Dollar. Rick Wagoner, CEO of GM, recently expressed similar sentiments. Japan’s response to these allegations has been to proclaim its innocence. For almost two years, Japan has refrained from intervention, a fact that has since been verified by official data. The Associated Press reports:

“The Japanese Central Bank intervenes in currency markets to keep the yen cheap and to create an advantage for its industry. Why doesn’t our government do the same for us?” LaSorda [CEO of Chrysler] said.

Read More: Chrysler CEO suggests U.S. could intervene in currency markets

In the last week, the Japanese stock market witnessed a massive ‘correction,’ as the Nikkei Index fell by almost 10%. Accordingly, many reckon the markets’ year-long strength may be coming to an end, and are warning against the possibility of investors removing their capital and transferring it to other countries, namely the US. In the last month, US capital inflows far exceeded the current account deficit, which can be attributed to continued faith in US capital markets. Analysts have cautioned, however, that the USD could depreciate if foreigners suddenly lose their appetite for investing in the US. The Financial Times reports:

[One economist] warned he “feared the worst for the dollar” if yield differentials were to become more attractive elsewhere. Another bearish factor for the dollar would be if equity weakness lowered expectations for further tightening, he added.

Read More: Yen shrugs off plummeting Nikkei

While currency traders often discuss interest rate differentials in the context of the USD and Euro, the concept is more closely tied to movements of the Yen. Japanese interest rates remain at depressed levels; the annual yield on Japan’s 10 Year note is currently 1.3%, a full 3 percentage points below the US equivalent. Accordingly, Japanese investors continue to pour money into foreign assets, where yields are significantly higher. This may prove increasingly problematic for the Yen, as Japanese corporations and individuals have suddenly found themselves with more cash to invest, due to the recovery of Japan’s economy. That they are investing profits and savings, respectively, into foreign securities rather than into their home economy, is not a good sign for the Yen. Bloomberg News reports:

Japanese investors bought 16.6 trillion yen ($145 billion overseas assets last year, according to figures based on reports released by the Ministry of Finance.

Read More: Yen Drops on Speculation Japanese Investors Seeking Higher Returns Abroad

For the last few months, several American trade lobbyists have publicly accused Japan of calculated intervention in forex markets aimed at holding down the value of the Japanese Yen. Japan’s repeated declaration that these claims were groundless and untrue was born out recently by Japan’s Ministry of Finance. Data indicates that from January 2003 until April 2004, Japan spent almost $350 Billion USD to slow the appreciation of the Yen by purchasing USD on the open market. Since April 2004, however, Japan has refrained from any intervention, which means its current value (to the chagrin of American trade groups) reflects market fundamentals. AFX News Limited reports:

The absence of dollar-buying and yen-selling via the Bank of Japan was attributed to the orderly reversal of the dollar’s weakness, reflecting the stronger fundamentals of the US economy compared with that of Japan.

Read More: Japan says it kept out of currency markets in 2005

In the last few weeks, the Japanese Yen has appreciated 4% against the USD, prompting officials from Japan’s Ministry of Finance to declare that they will be monitoring the Yen closely for unnatural fluctuations. The announcement was widely interpreted as a hint that the Ministry would intervene in forex markets and prevent the Yen from appreciating further. American industry lobbyists, in turn, responded with a show of outrage, urging US trade officials to prevent Japan from tampering with the value of the Yen. The Jiji Press reports:

Noting that Japan for years has massively intervened in currency markets to keep the value of the yen “artificially low,” he said, “Japan’s currency manipulation is a serious and damaging unfair trade practice that is causing permanent harm to the industrial core of the U.S. economy.”

Read More: U.S. Auto Official Raps Japan for Trying to Stop Yen Rise

As the Yen continues its 3-year slide against the USD, many American trade groups are beginning to cry foul, claiming Japan has taken steps to artificially depress its currency. At $842 Billion, the Bank of Japan’s foreign exchange reserves are currently the largest in the world. Some American firms believe this is a consequence of calculated intervention in forex markets- buying massive amounts of USD denominated assets in order to hold down the Yen and make Japanese exports seem more attractive. For the record, Japan insists that the Yen’s current value is the product of market forces. Not persuaded, American trade groups have begun lobbying the US Treasury Department to shift its attention away from China, and begin pressuring Japan to allow the Yen to appreciate. Reuters News reports:

“There is no excuse for the G7 to get together and sit around talking about China when the currency imbalances and Japan’s policy of strongly encouraging that isn’t even discussed.”

Read More: Trade groups at odds over yen tactics

In a recent interview, the Finance Minister of Japan shrugged off claims that the Yen was undervalued and stated his conviction that the currency is consistent with Japan’s current economic situation. Japan’s economy has performed well in recent quarters, spurred by an increase in exports, which were in turn driven by a weak Yen. An influx in foreign capital has buoyed Japanese equities, and the Bank of Japan is currently mulling an interest rate hike. Meanwhile, the USD is moving towards a 3-year high against the Yen, and currency traders and economists, alike, are laboring to reconcile the increasingly positive outlook for Japan’s economy with the dismal performance of the Yen. The Japan Times reports:

Kaoru Yosano, economic and fiscal policy minister, separately said the dollar’s surge was not so much due to economic fundamentals as to the fact that long-term interest rates are significantly higher — and climbing — in the United States.

Read More: Weak yen OK, reflects state of economy, Tanigaki figures

In the last year, the Korean Won has soared against the USD, while the USD, in turn, has appreciated significantly against the Japanese Yen. In line with the laws of triangular arbitrage, the Korean Won has pummeled the Japanese Yen, appreciating over 30% in less than two years. As a result, Korean exporters are having extreme difficulty competing with their Japanese counterparts. While economic fundamentals still seem to support Won strength, a Japanese trade surplus should soon force the Yen back up. In addition, we could see South Korea’s Central Bank intervene in forex markets in order to hold down its currency. The Korean Herald reports:

Along with the wider liberalization of the foreign currency market, a shift in the fresh global capital inflow into the European Union and Japan away from the emerging markets is expected to put downward pressure on the won next year.

Read More: Decoupling of won from yen seen easing in 2006

This week, Japan witnessed a feud with potentially far-reaching implications, as the Bank of Japan argued with LDP politicians over who has control of Japanese monetary policy. The spat began, when the Bank of Japan hinted publicly that it would like to reassert its independence in matters of monetary policy and hike interest rates. The announcement worried Japanese politicians for a couple of reasons. First, the popularity of the ruling LDP is closely tied to the performance of Japan’s economy; accordingly, LDP politicians want to be certain the economy is on solid footing before they adjust interest rates. Second, Japan has run massive fiscal deficits in recent years, and higher interest rates would raise the government’s cost of borrowing. Yen bulls should monitor this situation closely, for a hike in Japanese interest rates could provide an impetus for the Yen to reverse its systemic decline.

Read More: Japan’s Divided Policymakers

It is expected this quarter will marl the fourth consecutive of increasing economic growth in Japan. Accordingly, economists no longer believe deflation represents a threat; in fact, most economists are predicting core price inflation will exceed .5% this year. Japanese central bankers have responded to the prospect of rising inflation by suggesting an increase in short term interest rates, which are currently 0%. In Japan, however, the political establishment has just as much control in setting monetary policy as the Central Bank. In this case, Japanese politicians would like to make sure the Japanese economy is on solid footing before interest rates are hiked. Currency traders have not responded favorably to a prolonged period of easy money, as evidenced by the Yen’s continued decline. The Financial Times reports:

[One economist] believes year-on-year Japanese inflation is about to turn positive, as sharp falls in the price of mobile phones, electrical items and rice a year ago drop off the index. However, with the sustainability of this trend in doubt, he sees rates remaining at, or very close to, zero until April 2007 at the earliest.

Read More: Yen falls on battle over monetary policy

The USD has risen to a 25-month high against the Japanese Yen, including a 14% increase in this year alone. The Japanese economy has begun to show signs of life; its capital markets have performed those in the US, and Japan continues to run a massive current account surplus with the US. Hence, the USD’s continued appreciation against the Japanese Yen, and many other Asian currencies, has forex traders scratching their heads. Economists have turned to data on international capital flows in attempting to explain the weakness of Asian currencies. They believe rising US interest rates combined with the perceived stability of US capital markets are driving risk-averse investors, especially those in Asia, to shift capital into the US, which has generated massive demand for USD. The Wall Street Journal reports:

During the first eight months of this year, Japanese investors have poured $126 Billion into foreign stocks and bonds, up 19% from the same period last year.

Read More: No (Dollar) Gain without Pain

The Japanese Yen has not performed well against most currencies so far this year. Recently, however, the Japanese economy has shown signs of life and the Japanese government now seems committed to making certain structural reforms, which should further spur growth. In response, the Bank of Japan has hinted that as soon as it can be validated that the economy is on solid footing, it will begin raising interest rates, ending a period of negative real interest rates. This, in turn, should stem the Yen’s decline against the USD. Forexnews.com reports:

Looking forward, the looming end of the Bank of Japan’s quantitative easing by Q1 2006 coupled with and an eventual subsequent yuan revaluation against the US dollar, explains our medium-term yen bullish position, with 108 by year-end and 103 by end of Q1.

Read More: How Much More for the Yen?

Two prominent economists recently conducted a thorough analysis of Asia’s increasing foreign exchange reserves, the majority of which are held in US Treasury Securities, which are of course denominated min USD. The economists argue that the while the collective forex reserves of Asian nations have indeed skyrocketed in recent years, this does not necessarily signify that outright currency manipulation is taking place. Rather, they believe that these nations use their reserves as tools of monetary policy. For example, Japan may have grown its reserves to try to mitigate the possibility of deflation. Other nations view their reserves as a sort of contingency, to be used if the 1997 Southeast Asian economic crisis (which caused regional currency depreciation) repeats itself. China’s increasing reserves, argue the study’s authors, are largely a product of ‘hot money’ inflows, rather than a proactive attempt by China to hold down its currency. The Economist reports:

It is hard to accuse China of running a cheap-currency policy, since it passed up an opportunity to devalue the yuan at the time of the Asian crisis.

Read More: Asian squirrels

In a startling development, Junichiro Koizumi, Prime Minister of Japan, was overwhelmingly backed in the elections held over the weekend. Koizumi had called for the election after his bid to privatize Japan Post failed to pass in Japan’s Parliament, which was summarily dissolved. In a show of solidarity, Japanese voters have given Koizumi the power to make sweeping political changes and implement structural economic reforms. By coincidence, the election coincided with the release of certain economic data, which indicated Japan is now growing at a healthy 3.3%. It seems Japan’s economy is finally on solid footing, which certainly bodes well for the Yen. The Economist reports:

Investors also applauded revised economic figures that were released on the same day, showing that GDP grew at an annual rate of 3.3%, more than previously announced, in the second quarter.

Read More: Japan’s voters back Koizumi

When Junichiro Koizumi, Prime Minister of Japan, failed to receive the support of the legislature in his bid to privatize Japan Post, he immediately called for a snap election. On September 11, voters must decide whether to grant Koizumi more power in liberalizing Japan’s economy, as well as the authority to trim government spending and public debt. While polls indicate 50% of Japanese currently support Koizumi, many investors are much more bullish, going so far as to price a Koizumi victory into markets. Investors believe the Japanese economy would surely benefit from such a victory, as would the Japanese Yen. Bloomberg News reports:

Demand for the yen may increase on speculation an election win will give Koizumi more power to push through policies to bolster the economy.

Read More: Yen May Gain After Second Poll Shows Koizumi’s Rating Increases

The IMF recently released a much-anticipated report on Japan’s economic prospects. The report was overwhelmingly positive, forecasting growth of 1.8%, compared to 2.4% last year. At the moment, inflation appears to be negative, meaning Japan’s Central Bank is not likely to raise interest rates anytime soon. On the political front, Prime Minister Koizumi has failed in his quest to privatize Japan Post, despite drawing wide international praise for his efforts. As a result, Koizumi has called for a snap election to be held in the not-too-distant future. The implications vis-à-vis the Japanese Yen are ambiguous. While Japan’s economic future is bright, its political future is uncertain. Stuff New Zealand reports:

Some directors said intervention could be a last resort if the yen rose high enough to threaten the economy while most others said the economy was in better shape to handle a stronger currency, which can make it tougher for a country’s exporters to compete.

Read More: IMF gives Japan’s economy short-term tick

Bloomberg news recently conducted a survey, asking professional currency traders to gauge their sentiments on various currencies. While there was tremendous variation in the results, a majority of traders admitted optimism in the Yen. A Citigroup analyst opined that bearish sentiment on the Yen had reached ‘extreme’ levels, and he was now advising clients to take positive positions. Other analysts agreed, noting renewed confidence in Japan’s economy. However, many were careful to note that the failed privatization of Japan Post would not be good for the Yen. Japanese lawmakers are set to vote on the bill by August 5th.

Read the full results of the survey

In the short-term, reckon analysts, the Japanese Yen will hinge on the actions of Japan’s Prime Minister, Junichiro Koizumi. The reason is Koizumi is currently pushing for the modernization of Japan Post, which not only manages Japan’s postal system but also represents the world’s largest savings bank. Koizumi is so adamant that the bill passed, that he has threatened political upheaval should it fail. Some analysts feel Japan Post will likely be privatized, despite the uproar surrounding it, while others put the odds closer to 50:50. While analysts disagree over the bill’s likelihood of success, all agree that the situation will continue to dictate the movement of the Yen. The Financial Times reports:

“It remains close, and markets dislike uncertainty, so with the data calendar light for now, the yen may face further downward pressure,” said a senior forex strategist. However a number of analysts pointed to the scope for the yen to rally if the bill is passed.

Read More: Yen slides on renewed Koizumi doubts

The Japanese Yen is looking especially perilous, due to increasing political uncertainty.  Junichiro Koizumi, Japan’s Prime Minister, has undertaken an effort to privatize Japan-Post, which among other things, is the world’s largest savings bank. Unfortunately for Koizumi, there are several prominent Japanese politicians who are opposed to the move, on the grounds it may result in job losses.  Koizumi’s administration has witnessed growth, albeit miniscule, in Japan’s economy, following a decade-long recession. As a result, investors and traders are not reacting positively to the potential rejection of Koizumi’s proposal. A senior Japanese politician and Koizumi supporter suggested such a rejection would have a significant impact on asset and currency markets. Bloomberg news reports:

“Koizumi has been a source of stability after a decade of economic turmoil in Japan,” said a [senior economist].  “Investors like stability. The prospect of removing that stability would not be good for the yen.”

Read More: Yen Touches 14-Month Low Against Dollar, Tumbles Versus Euro

US Representative John Dingell has introduced a bill that addresses currency manipulation. Specifically, the bill would require any nations that enter into future trade agreements with the US to permit their currencies to float. Currently, a number of countries, mainly in Southeast Asia, either explicitly peg their currencies to the USD or intervene in forex markets to prevent their domestic currencies from significantly fluctuating. Dingell has argued currency manipulation is tantamount to a trade subsidy or tax break, as a nation’s goods and services are made artificially cheap by an undervalued exchange rate.  He cited China and Japan as serial currency manipulators who have hamstrung many American firms. The Detroit Free Press reports:

Dingell’s bill would apply to all countries that trade with the United States by requiring the free trading of currencies as an objective for every new trade agreement. The bill also would require the administration to report on currency manipulations to Congress and seek compensation for harmed industries.

Read More: Dingell opposes currency manipulation

New data indicates Japan’s trade surplus is declining, which spells trouble for the recession-prone economy.  On a monthly basis, Japan’s May trade surplus was $2.7 Billion, down 68% from the previous year.  Most economists had forecasted a decline of 5-10%.  The impact of this development on Japan’s economy remains to be seen.  Japan has just begin to emerge from its 4th recession in 15 years, and is still heavily dependent on exports to drive economic growth.  Furthermore, Japan is counting on a revaluation of the Chinese Yuan to spur trade with its Asian neighbor, but there are no guarantees if and when this move will occur.  Predictably, the Yen is losing value against most major currencies, as investors weigh the implications of the trade data. Bloomberg news reports:

“People have been buying the yen because of it’s healthy surpluses, and now it looks like they’re shrinking,” said a senior HSBC currency strategist.  “I’d be skeptical of buying the yen at these levels.”

Read More: Yen Declines Against Dollar as Japan’s Trade Surplus Narrows

For the last few years, Japan’s economy has been nothing short of pathetic. Unemployment is still high, and deflation is a constant concern. Recently, however, it seems Japan may be on the brink of growth, and Japan’s Central Bank is already anxious to tighten.  Maybe a little too anxious. The Bank of Japan is determined to contain inflation- which is currently infinitesimally low- at the expense of economic growth. It has already announced that it will begin tightening monetary policy, through a combination of higher interest rates and a lower money supply. It has also hinted towards a tightening of fiscal policy- raising taxes to offset a large budget deficit. However, economic growth can not yet be taken for granted.  The Economist reports:

Recent mis-steps by both politicians and technocrats have highlighted three of the biggest risks to recovery. One is China, with which Japan’s relations hit a new low this week. Figures released on May 25th showed…the volume of exports fell, and has been roughly flat in the past three months.

Read More: Land of the Three Mistakes

In the early 1990’s, Japan’s economy plunged into recession. Japanese Central Bankers were dumbfounded, and uncertain as to how they could induce a recovery.  10 years later, it seems they have finally figured out the formula: a loose monetary policy- and then some. First, the central bank lowered real interest rates, until they were effectively negative. This resulted in a multiplication of the money supply.  Next, the bank injected fresh cash reserves into insolvent banks, which had suffered as a result of massive unpaid loans brought on by recession. These banks, in turn, used the cash reserves to lend money to struggling businesses in an effort to revive the economy. It seems to have worked.  Now, as the economy is growing at a healthy rate, the Central Bank must slowly unwind this policy, by raising interest rates. This, however, is easier said than done. The Wall Street Journal reports:

If it [Central Bank] ends the easy-money policy too soon, it could snuff out economic growth. But maintaining super-loose credit too long during an economic recovery could be like spraying gasoline onto a fire, causing a flare-up of inflation.

Read More: The Real Trick to Japan’s Easy-Money Policy is How to End It

A recession is defined as two quarters of negative real GDP growth. By definition, Japan experienced a protracted recession last year. However, the recent release of positive first quarter economic data heralded the end of negative growth. Japan’s economy grew at an annualized rate of 5.3% in the first quarter, which represents a significant increase from the past couple of years. It seems Japan’s recovery was spurred by a variety of factors. Increases in disposable income coupled with a rise in consumer confidence triggered a significant increase in consumption. Japanese consumers are notoriously frugal, hoarding disposable income in expectation of future recession. This sudden change may prove momentous, as Japan may be able to rely on internal rather than external demand as a source of future growth. In fact, Japanese exports have actually begun to decrease, due largely to the the Yen’s appreciation. BNP Paribas reports:

Net exports contributed negatively to GDP growth, cutting it by 0.1 percentage points. Real exports have fallen for the first time in more than four years, down by 0.2% q/q, while real imports were up a mere 0.5% q/q. According to customs data, the nominal drop in exports over the quarter mainly results from the fall in exports towards Asia, which roughly represent about half of Japanese total exports.

Read More: Japan: GDP growth strongly rebounded in Q1

As rumors of Chinese Yuan revaluation intensify, investors have been searching for ways to profit. Many have simply purchased massive quantities of Yuan, guided by the belief that the Yuan will instantly appreciate upon China’s allowing it to float. Other investors have found a more creative way to play the rumors, by investing in Japanese Yen. Such investors speculate that Japanese exports will instantly become more attractive when the Yuan is allowed to appreciate. Certainly, Chinese revaluation will make Japanese imports more affordable to Chinese consumers. However, experts insists this increase will be negligible.

Many investors also believe that more expensive Chinese products, brought on by Yuan revaluation, will also increase exports for other Asian countries. While such logic can be extended to other countries with low cost labor forces, it does not apply to Japan. Experts point out that Japan and China have vastly different economies, and do not compete in the same markets. China is known for its textiles and labor-intensive wares, while Japan is known for its technology, and machine production. Reuters reports:

[A Representative for] JP Morgan Chase Bank said Japan’s exports to China did not grow even when the yuan, along with the dollar, gained against the yen. He noted that much of Japan’s exports to China are parts for products that are then exported again to markets such as the U.S. and Europe. Global demand is far more important in determining the strength of Japan’s exports, he said.

Read More: Yen to rise when China frees yuan? Don’t bet on it

The Bank of Japan recently released its annual "outlook report." As suggested by its title, the report summarize the bank’s forecasts for future economic growth. With regard to the year 2005, the bank lowered both its forecasts for growth and inflation. In spite of a global economic recovery over the last couple years, Japan’s economy may actually contract this year. At .1%, inflation is a non-issue. Japan’s Central Bank has kept interest rates low, so as to encourage investment, and maintain low borrowing costs for Japanese firms. None of these measure have been able to stimulate the economy, however. The Bank of Japan also released its forecasts for 2006, which were quite bullish. Many economists, however, take these predictions with a grain of salt, and view them as political- rather than economic- statements. Morgan Stanley reports:

The Bank aims to preserve market expectations for an exit strategy by its bullish forecast together with the suggestion about the reduction of the current account balance, thereby avoiding an over-reaction by the market. Also, the Bank has a track record of trailing economic turning points due to its stubbornness.

Read More: Japan: A Long Shot

How the Japanese Yen will fare in the coming months is currently a popular topic of discussion. The Japanese Yen has appreciated for several consecutive years, and many investors are bullish on its future. They point to an improving economy, made possible by low interest rates. The Japanese government seems to agree, having recently upgraded its assessment of the Japanese economy for the first time in almost a year. Many analysts agree, citing technical indicators as evidence that now may be an especially good time to buy the Yen. 

But, for every bull, there’s a bear, and this situation is no exception. Japan is almost completely dependent on other nations for raw materials, notably oil and natural gas. As the prices of these commodities rise, Japanese businesses and consumers must spend more of their free cash and disposable income, respectively, on purchasing these commodities. In most countries, the profits earned by domestic producers of raw materials offsets the higher costs born by other businesses that use these raw materials as inputs in production. This trade-off does not exist in Japan, and each additional Yen spent on gas causes a proportionate decline in Japanese GDP, which could weaken the Yen. Furthermore, this increase in the cost of raw materials has left Japanese companies with less profit. Many foreign investors are selling Japanese equities, which has caused a significant outflow in foreign capital. Only time will tell who is more prescient- the bulls or the bears.

Read More: Yen Nears Its Bottom

Japan’s Central Bank responded to rumors that it was gradually diversifying its foreign exchange reserves with an emphatic denial. All eyes have been on Japan recently, as rumors of diversification have surfaced and been squashed- only to resurface. Japan is home to the world’s largest foreign exchange reserves, with over $800 Billion in dollars alone. It has bought over $300 Billion Dollars in the last two years in an effort to stabilize the Yen, which continued to appreciate. Now, Japan’s Central Bank is faced with a dilemma: continue buying Dollars in a futile effort to stabilize the Yen, or Sell Dollars to try to recoup losses on its forex reserves. Japan has pledged not to diversify, so as not to roil currency markets, but many experts feel Japan may soon run out of options. Furthermore, Japan is treading dangerously, as other Asian nations are watching it for cues on how to handle their respective reserves. A rumor last month exemplified just how precarious this situation is. Reuters reports"

Prime Minister Junichiro Koizumi’s comments last month that diversification in currency reserves was necessary sparked a wave of dollar selling as the comments were interpreted as implying a reduction in dollar holdings.

Read More: Japan Denies Changing Currency Mix in FX Reserves

The Bank of Japan released its Tankan survey this week, which measures Japanese producers’ confidence in the economy. The numbers were not good, meaning Japanese are not optimistic about the state of their economy. Many fear Japan is headed towards its 4th recession in less than 15 years. As a result, Japan experienced a substantial outflow of capital, as nervous investors moved their money to more stable economies. The removal of assets trickled down to the exchange rate, as the Japanese Yen fell over 1% against all major currencies. Business confidence is at a 4 year low, and investors are already speculating on the results of next month’s survey. Bloomberg news reports:

A foreign-exchange strategist in Tokyo at Deutsche Bank AG said, "People want proof the economy is recovering. The yen is going to fall."

Read More: Yen Falls on Tankan

Japan recently threatened to intervene on behalf of the Yen, which has appreciated by over 30% against the dollar, over the course of 3 years. The reason for the intervention is a decline in Japanese exports, due in part to a stronger Yen, which may be preventing Japan’s economy from achieving real economic growth. As a result, Japan threatened to intervene if the Yen continues to appreciate against the USD.

The announcement was made almost exactly a year after Japan’s last bout of intervention ended. In the first few months of 2004, Japan’s Central bank bought large blocks of USD, to prevent the Yen from strengthening. Sure enough, the Yen stabilized. Since then however, the Yen has resumed its climb, and the value of the USD that Japan purchased has declined proportionately. In fact, it is estimated that Japan lost over $100 Billion as a result of the intervention. Some analysts believe that Japan made the announcement to try to drive down the Yen, without actually intending to deliver on its threats. The Times Online reports:

Currency analysts said that the comments were part of a strategy used by Japan of first using the threat of intervention to move the markets before stepping in with massive buying of dollar assets. Observers also pointed out that the statement used the same language as earlier pre-intervention speeches, including the notorious line that Japan will step in “if exchange rates do not reflect economic fundamentals”.

Read More: Japan threatens to resume artificial weakening of yen

Junichiro Koizumi, prime minister of Japan, sent the dollar reeling as he warned  diversification of Japan’s foreign exchange reserves may be "necessary." This announcement comes in the wake of a similar warning issued by South Korea’s Central Bank. The difference being Japan’s dollar reserves, at $840 Billion, more than quadruple those of South Korea. Japan’s finance minister was quick to qualify Koizumi’s comments, saying that the prime minister was referring to diversification of the dollar reserves into different dollar-denominated assets, not into different currencies. However, the damage had already been wrought, as the dollar reached short-term highs against both the Euro and the Yen. The news also sent US treasury yields soaring, as bondholders feared the US might have to offer a higher return to prevent the banks from diversifying. The Financial Times reports:

Although the market remains skeptical of any imminent Japanese diversification, Tony Norfield, global head of foreign exchange strategy at ABN Amro, said: “If there is a political debate about in Japan about what to do with their reserves, that will put the spotlight on the dollar.”

Read More: Koizumi puts markets in a spin