Central Bank of Japan Appoints Leader

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

Return of the Carry Trade?

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

Japan (Also) Mulls Intervention

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

Bank Collapses, Dollar Plummets

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

The Yen Marches On

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

Kiwi Rises and Falls with Risk Aversion

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

Yen as Proxy for Risk Aversion

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

Volatility Drives Yen

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

Risk Aversion Lifts Carry Trade

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

Yen Buoyed by Exporters

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

Carry Trade Gains Favor

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

Volatility is Hurting Carry Trade

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

Carry Trade Continues to Suffer

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

Yen Carry Trade: Going Strong or Coming to an End

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

Bank of Japan Leaves Rates Alone

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%

Japanese Forex Reserves Near $1 Trillion

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 Yen Also Rises

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

Yen Drops As Investors' Desire For Risk Returns

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

Dollar Holds Steady as World Awaits US Data Reports

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

Yen Bounces Back From Wednesday's Drop

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

Investment in European Stocks Weakens Yen

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

Credit Problems Strengthen Yen

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

Yen Suffers as Carry Trading Resumes

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

Dollar and Yen Continue to Strengthen

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

Japanese Avert Trouble Spreading From West

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

Slight Unwind in Yen Carry Trade

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

Yen Descends to Record Low

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

Yen Falls to Record Lows

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

No End to Carry Trade?

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

US Congress Discusses Yen Manipulation

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

ECB cautions against Euro appreciation

“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'

Yen Carry Trade Remains Popular

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

BOJ spurs carry trade

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

Carry Trade Under Pressure

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

Carry trade returns in force

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

Yen settles down after turbulent week

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

Sudden risk-aversion drives Yen upward

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

Carry trade partially unravels

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

Commentary: What will it take to end the Yen carry trade?

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.

Yen fails attempt at appreciation

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

Paulson unfazed by Yen

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

Yen slides to new lows

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

G7 Meeting may cause Yen to appreciate

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

Low rates continue to depress 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

Low volatility drives carry trade

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

Economist Urges Asia to accept fall of USD

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

Bank of Japan to raise rates

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…

Carry trade may buoy Yen

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

Russia buys Yen for forex reserves

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

North Korea weighs on 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

Yen nears all time-low

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

G7 avoid talk of Yen intervention

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

G7 will discuss Japanese Yen

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

China and Japan discuss currency appreciation

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

Speculators get burned by carry-trade

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

Carry trade continues to dampen Yen

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

US automakers accuse Japan of currency manipulation

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

China Raises Reserve Requirement

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

Yen Rises on Eve of BoJ Meeting

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

Laws of Economics may soon catch up with Dollar

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

Capital flows data buoys Yen

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