The Secret Behind the Soaring Yen - And How High It Could Fly

In the past couple of months, a lot of attention has been placed on the euro. The single currency has fallen hard and fast. But few people are focusing on the strength of the Japanese yen.

The Asian currency has appreciated rapidly over the last eight months against the US dollar. But more importantly, it has strengthened against the euro. From an exchange rate of 140 yen per euro back in the beginning of the year, it has jumped to just 108 yen per euro in the month of June. That’s a 23% advance in a little over seven months.

But it isn’t the Japanese economy that has helped the yen appreciate. In fact, growth in the world’s second-largest economy continues to remain lukewarm, and consumer confidence and consumption are spent. The country has also seen political turmoil in the past few months, after the prime minister was recently forced out of office.

So what is powering the yen higher? In a word, fear.

Investors are worried about a potential double-dip recession and an economic depression, pushing the yen higher against the euro currency. Essentially, there are rising fears that global deficit reduction strategies are likely to choke off nascent recovery. But Japan has already been through the wringer – it has cut all it can cut. By default, it’s ahead of Europe, which came late to the budget-cutting party. So foreign exchange markets are likely to see further appreciation in the Japanese yen.

We’ve seen this type of appreciation in the EURJPY before. During the financial crisis of 2008, the Japanese yen was being exchanged for as high as 170 per euro. During the following nine-month decline, the currency pair lost almost 33%. Fears of an economic and financial doomsday scenario helped to fuel the yen’s rise as investors viewed the yen as a safer bet.

Before the financial crisis, the Japanese yen served as the main funding currency for the popular carry trade. This is where investors bought a higher-yielding currency – like euro – and sold lower-yielding currencies – like the yen. As soon as risk appetites disappeared, so did the advantage of holding this trade. Risk aversion led many investors to close or reverse their positions in EURJPY, making it less and less of a profitable proposition – boosting the yen.

The same can be said about what has taken place over the last couple of months. With European banking concerns and a Greek default hovering over the markets, investors have become more risk averse. The recent fear has helped to boost demand for the safe haven yen once again.

But how likely are we to see a repeat downfall? And how far are we to fall?

With markets spooked, the likelihood for further declines in the EURJPY pair are pretty good. Currency markets can be sensitive in bad times, even more so in worse times. Just the smallest bit of pessimism can trigger a landslide – and the European euro/Japanese yen isn’t immune to this fact. As long as pessimism and risk aversion remain dominant themes in the current market environment, there will be plenty of buyers of Japanese yen against the European euro.

This point is especially important for Japanese exporters. Companies that export goods and products to Europe will likely see their overseas profits disappear due a stronger yen. The losses appear when the euro profits are exchanged into Japanese yen – it will take more euros to create the same amount of yen profit. In this losing situation, Japanese exporters will look to buy yen while selling euro in the market – helping to minimize the losses they will see in their own profits. Activity like this – expected to be widespread throughout the country – will help to support further JPY strength and EUR weakness.

Given the fact that markets also tend to overshoot, yen momentum is likely to continue far above current levels should we see more market fears and concern from here on in.

If you’re hoping to capitalize on the opportunity or trying to hedge a portfolio, there are several options available. In particular, currency ETFs present the best method of participating in the trend for further yen strength. For those bullish the yen, CurrencyShares Japanese Yen Trust is one such method. Available as FXY, the ETF has moved in relative lockstep with the underlying currency rising by almost 5% since the beginning of the year.

There are also some key indicators to help with timing the trade. First, watch the Dow Jones Industrial Average. The index and the yen have a strong inverse correlation – strength in the Dow will be reflected in a weaker Japanese yen, and vice versa. So, should the Dow Jones post a significantly negative day, yen strength is likely to be in the making.

And watch China. Right now, China serves as the symbol of the economic recovery. So any news that may reflect badly on this symbol will help to spark a run to safe havens. That should mean a buying spree in Japanese yen – as risk aversion takes away from euro strength.

Already at 9-year highs, it is very feasible that the EURJPY could test 10-year price targets very soon if the current risk environment persists.

Richard Lee
for The Daily Reckoning

The Daily Reckoning