Speculators keen on betting against the yen should read the writing on the wall. Currency-carry trade - that financial smoke and mirrors by which low-interest yen is borrowed to invest in high-yielding currencies - has gained the attention of both market players and observers in recent weeks. Not least of which is Japan's finance minister who warns it may soon be time to cash out of the game.
The weak yen has long buoyed Japanese exports at the expense of more equitable overseas trade and to the chagrin of foreign investors. And carry trading is no stranger to criticism for artificially inflating global liquidity, while helping the United States, Briton and Australia finance current-account deficits. One-way currency bets are also credited for pushing the yen's trade-weighted real-effect value to a 22-year low, which only adds fuel to the carry-trade fire despite such criticisms.
To be sure, yen-carry trade can be as lucrative as it is risky, with 2007 estimates as high as U.S. $1 trillion at stake in this largely off-the-books market. These days, however, the magic that speculators use to capture the difference between Japan's 0.5 percent interest rate (making the yen the developed world's most undervalued currency) and those such as the United States' 5.25 percent is drawing criticism from corners at home as well as abroad.
Most notably is Japanese Finance Minister Koji Omi's unprecedented warning last month about the risk of one-way bets against the yen, signaling it may spur the Bank of Japan to break with recent tradition and intervene. The desired effect may have been little more than the ensuing market reaction which prompted the yen to pull away from a 4 1/2-year low against the U.S. dollar. But the warning of risk is not without substance.
The same can be said of the International Bank for Settlements' annual report which recently warned, "clearly something (is) anomalous" about the yen's weakness. It's an assessment that few would disagree with, if not consider an understatement.
The yen is undervalued by about 28 percent, writes Nicholas Vardy, editor of The Global Guru. Like others, he warns that with Japan's economy showing clear signs of recovery the Bank of Japan has less incentive to keep interest rates low, which points to a future rally of the yen. And while the Daily FX notes the yen's takeoff against the U.S. dollar may mean Omi's cautioning is due in part to pressure from Washington, it's not to say that when combined with other factors it will be the extent of future currency intervention by Tokyo.
Cary traders may well be right in anticipating little more than a 0.25 percent rise in Japan's interest rate by September (a recent Bloomberg poll shows 29 out of 34 economists predict it will reach 0.75 percent by then) but what of other unforeseen influences? It's likely that yen-value distortions will eventually be corrected, and carry-trade liquidation is often fast and furious without warning as speculators embark on a selling frenzy.
After Russia defaulted on its debt in 1998, the yen skyrocketed by 20 percent in two months and by another 13 percent within three days when Tokyo revealed plans to bailout its banks, Vardy notes. That and the previous year was the last time Japan intervened to buy yen in currency markets, as foreign investors dumped Japanese assets en masse.
True, the Japanese government usually steps in to keep the yen down in favor of exports as it did last in 2003 and 2004, making this Tokyo's longest hands-off-the-market stint. But it's also worth noting that Omi's June comments were the first in a long time from a Japanese finance minister that sent such a clear signal to the currency market.