The story is the story

Of all the reasons for the yen to be on the upswing, the sub-prime hedge fund story seems to be the one that has captured traders’ imagination. That we have no hard evidence of yenfunded hedge-fund failures and no evidence of a lending pullback, whether government-mandated or not, is no deterrent to traders. It’s a juicy story. It makes sense. All it will take is one outright yen-funded hedge-fund failure to send the yen to the moon.

The yen can also go to the moon if carry trades actually do get unwound. We have been pooh-poohing that story, which has been used to explain any and every minor bounce upward in the yen for the past six months, because hedge fund managers have a “strong hand.” It's not easy to stampede them out of lucrative positions. But each manager has a breakeven point and nerves get frayed even when the yen is hundreds of points away. After all, currencies can move hundreds of points in a short while and currencies are famous for overshooting, too.

More importantly, folks riding the coattails of the yen carry trade, including those with plain vanilla futures and forwards, are easy to panic. As risk aversion rises with every new story about losses in subprime and other collateralized debt that was mispriced, incompetently rated by the ratings agencies, or can’t be marked to market with any confidence, the carry trade gets lumped in with other paper deemed “high-risk.” This is not accurate — with the carry trade, all you need to know is your breakeven point. You can count on the forex market to provide sufficient liquidity for an orderly exit at just about any hour of the day or night.

With truly high-risk paper, the unknowns are plentiful, including markets so thin (illiquid) that no trading gets done at all. But the relative ease of exit doesn't matter to those prone to panic — the yen carry trade is considered speculative, and plenty of traders will simply dump positions.
Add to that a possible rate hike and a government determined to rise in the ranking of global financial centers on the back of a high currency and you have a recipe for further gains.Is this a castle built out of spun sugar? You bet.

The whole thing can come crashing down if the sub-prime problem fades away with no big institutional failures, Abe loses the election, the BOJ refuses to raise rates because there is no inflationary reason to raise rates, and the timetable for restoring Tokyo to world status is seen to be a project for a decade, not the next three months. But in the meantime, you have to go with the flow.