The long-term track record of competitive currency devaluation and export-led growth has not been a happy one wherever it has been tried. Unfortunately for Japan and the other major East Asian economies of China, South Korea, and Taiwan, this region appears wedded culturally to the mercantilist model.

As Japan emerges slowly from the deflationary recession cycle it has faced since 1990 and grapples with what is thought to be the oldest society in human history, we can expect them to hew to their export-led model. Consumption in an aged society with government debt in excess of 130 percent of GDP is not the way to grow, so they probably have no choice but to maintain export growth. This means protecting their markets from Chinese and other competition.

As much as Japan might like to end the easy money era, they have not availed themselves the opportunity to do so. The yen carry trade is likely to persist as a form of vendor financing, one that has yet to weaken the JPY. We can expect the JPY to continue its unique path of slow declines and violent rallies as these policies remain in place.

On a chart the JPY will continue to look like no other currency and will insert significant volatility into the DXY. And Japan will continue to be the currency nail everyone else tries to hammer down.

While currencies such as the Canadian dollar (CAD, see “Remember the Forgotten Currency,” Currency Trader, February 2006) appear driven to a large extent by relative capital market flows, the JPY increasingly has ignored these effects in recent years.

Prior to the onset of quantitative easing, the JPY had a modest correlation with the FRR from one to 10 years in the Japanese market and no relationship with the USD FRR from one to 10 years. After quantitative easing began, the JPY FRR remained largely frozen at steep levels while the USD FRR both steepened and flattened at this horizon. The JPY ignored both curves.

The disconnection between the JPY and relative stock index movement is even more pronounced. Prior to the failure of the hedge fund Long Term Capital Management in fall 1998 — an event that triggered a sudden and massive (11 JPY per USD in one night) revaluation of the JPY — the relative performance of the Nikkei 225 to the broad-based Russell 3000 index declined regardless of the JPY’s course. After 1998, and to an extent largely unappreciated by many investors, the Nikkei re coupled with the world’s major stock indices while the JPY remained in a wide trading range between approximately 105 and 125. True, the Nikkei’s 2005 rally occurred while the JPY weakened, but as the opposite relationship of a weakening Nikkei combined with a strengthening JPY never occurred, we cannot posit any causal relationship.

The extent of Japan’s monetary easing is difficult to comprehend even in hindsight. Let’s compare the yields on three-month JPY and USD LIBOR on logarithmic scales (JPY LIBOR would be difficult to depict otherwise). The historic easing and subsequent tightening engineered by the Federal Reserve is highly visible.

The USD scale goes down to 1 percent. The JPY scale has to go down another two cycles, to .01 percent. Japanese yen LIBOR fell below 5 basis points in 2003, an absolute level more than 20 times lower than the USD low-point. It is not the level of JPY or USD rates that determine how the non deliverable forwards will be priced, but rather the reinvestment rates three months from the time of the spot transaction. The best metric for these is the forward rate ratio (FRR) between six and nine months.

This is calculated by taking the forward rate between six and nine months (the rate at which you can lock in three-month borrowing starting six months from now) and dividing it by the nine-month rate
itself. The more the FRR exceeds 1.00, the looser the money policy is. A FRR less than 1.00 indicates an inversion of the money market curve.

The JPY FRR was less than its USD counterpart for long stretches of time in the first half of the 90s, and predictably the JPY soared against the USD in reflection of Japan’s tighter money policies. This changed abruptly after the JPY peaked in March 1995, and then the JPY predictably weakened. However, during the long stretch after quantitative easing began, the JPY rose until late 2004, at which point the Federal Reserve’s rate-hike campaign began to firm the USD.

Can we therefore adopt a simple trading strategy — going short the JPY as long as the JPY FRR exceeds its USD counterpart? Absolutely not: Not only is the impending end of the Bank of Japan’s quantitative easing program going to put an end to the massive borrowing and-selling of the JPY, but Japan’s customers will need to buy JPY to pay their bills. The JPY may drift lower over time but be interrupted by violent short-covering rallies. Sell and hold will not work.

This demands explanation. Logic would dictate the manic creation of yen would make each one worth less. But during this period global borrowers, rather than Japanese borrowers, swooped in to take advantage of the cheap JPY. The colossal purchases of U.S. Treasury securities by official Japanese institutions (read: the Bank of Japan) during this period is but one example of what became known as the “yen carry trade.” A non-Japanese borrower would borrow JPY at near-zero percent rates, swap the JPY for their currency and then lend that currency at the higher available rate.

The risk of this trade was JPY appreciation, but as the Bank of Japan’s policy appeared to be to keep the JPY from appreciating, hedgers simply bought barrier call options and other capping devices on the JPY for a relatively cheap hedge. The yen carry trade was a form of vendor financing: By financing Japan’s customers, the Bank of Japan was able to support Japan’s export industries in the face of the Chinese onslaught.

There are several ways to illustrate the extent of the yen carry trade. One is to compare the annualized growth of Japan’s monetary base (its currency circulation plus reserve deposits at central banks) against M2 plus certificates of deposit. The former can grow by central bank action; the latter grows by extension of credit domestically. Once quantitative easing began, monetary base grew as rapidly as 31 percent on a year-over-year basis. M2 growth never exceeded 4 percent over this period. Someone other than Japanese banks had to be taking advantage of the cheap JPY.

The original theory advanced on behalf of floating exchange rates held they would produce self correcting trade balances (see “The dollar index and ‘firm’ exchange rates,” Currency Trader, December 2005). A trade-deficit nation’s currency would depreciate and have less power to purchase goods and services in the world market, while a trade-surplus nation’s currency would appreciate with the opposite effect. While this is true for the U.S. dollar (USD) and nearly every other currency of significance, the U.S. trade deficit has been uncorrelated with the DXY for more than 30 years.

However, Japan’s merchandise trade surplus does appear to be related to the JPY. If we map a 12-month rolling average of the Japanese trade surplus against a 12- month rolling average of the JPY, we find a stronger yen appears to lead a reduced trade surplus by about 18 months; the opposite is true for a weaker yen. The abrupt strengthening of the yen in the mid-90s reduced the monthly trade surplus on the order of ¥650 billion from peak to trough. A second way of looking at the same phenomenon is to map Japan’s exports as a percentage of its gross domestic product (GDP) against the JPY. The two series align closely between 1985 and 2001, and then diverge sharply afterwards. Before the Bank of Japan began (in March 2001) its program of “quantitative easing,” a technical term for shoving money down commercial banks’ throats, a stronger JPY reduced exports as a percentage of GDP. After quantitative easing began, the export percentage rose without the JPY weakening at all.

It is fair to note, as the Japanese themselves do, that Japan is one of the more group-oriented societies in the world. An old Japanese proverb warns, “The nail that sticks up will be hammered down.” How odd, then, that the Japanese yen — 13.6 percent of the benchmark dollar index (DXY) — is a currency with its own rhythm. It truly marches to the beat of a different drummer.

To an extent casual observers have difficulty believing, most currencies are more or less disconnected from their country’s external trade balance (see “What Drives the Dollar Index?” Currency Trader, January 2006).

Instead, they tend to rise and fall as a function of interest-rate differentials, yield-curve shapes, and returns on assets denominated in that currency. Japan and the yen (JPY) are an exception for several reasons. First, Japan has a virtually permanent trade surplus with the world as a whole and the U.S. in particular. This means importers of Japanese goods must buy JPY to settle their purchases, regardless of the return on holding yen.

Second, as we shall see in detail, Japan’s long experience with deflation and its failed attempts to resuscitate its economy with near zero-percent nominal interest rates made normal covered interest arbitrage impossible and produced some odd effects in the market.

Third, while all governments have meddled in foreign exchange markets, none have meddled as blatantly as Japan. The country rightfully fears its export markets are going to be captured in large measure by other Asian exporters; China in particular.

Fourth, Japan reacted to trade protectionism in the U.S. and elsewhere with a combination of bloated public works expenditures designed (in vain) to increase consumption, occasional policies favoring a strong yen, and direct investment in customer countries (e.g., the automobiles formerly exported from Yokohama are now made in Tennessee and Ohio).

Finally, even as currencies worldwide and the DXY are increasingly linked to both the long end of their respective national yield curves and stock index performance, the JPY appears unrelated to either of these capital market considerations.

Now let’s conclude by taking a longterm look at the yen relative to Japanese inflation. The declining inflation rate in Japan led to continued firming of the yen except during those periods when the U.S. consciously pursued a strong dollar. These retracements are noted with green trendlines. The last two periods so marked, the late 1980s and mid- 1990s, saw both an upturn in Japanese inflation and a weakening of the yen. We would have to conclude future yen weakness will emerge if the BOJ is successful in increasing inflation, unless inflation and interest rates rise faster outside of Japan.

The opposite effect — a weaker yen leading to an upturn in the rate of inflation — does not appear in the data at all. The 2006-2007 time frame, called a period of yen weakness by some, is not a period of yen weakness by historic standards. Moreover, the unwinding of various yen carry trades and widespread expectations of more relaxed monetary policies in the U.S. and Europe during the July-August credit crunch actually strengthened the yen.

Eventually the credit crunch will end and the world’s central banks will return to their mission of the first half of 2007 — fighting inflation via higher short-term interest rates. The lesson for currency traders is clear: Whenever a central bank declares war on its own currency and wins, go with the flow and sell that currency. What has made the last decade tough for yen traders is deflation in Japan. If this ends — and the BOJ appears ready and able to end it prior to July 2007 — the trade of selling the yen could be a profitable one for a long time to come.

Inflation is a scourge, so you take notice whenever someone tells you they would like to see a little more of it.

The Bank of Japan (BOJ), which has been seeking every reason imaginable to end its policy of near-zero interest rates, produced a study in May 2007 titled “The Costs And Benefits of Inflation: Evaluation For Japan’s Economy.” The study is 63 pages long, filled with quantitative macroeconomics and attempts to find the “optimal inflation rate” for Japan, which the BOJ concludes are annual consumer price increases between 0.5 and 1.0 percent.

Why does the BOJ consider some inflation to be better than no inflation, or better than the deflation Japan has experienced over much of the past decade? Because, as we have discovered in several venues since July 2007, modern economies depend on credit. Any such economy has a preponderance of debtors over creditors, and inflation allows these debtors to repay their loans in a depreciated currency. The logical rejoinder is why creditors would not demand full protection from inflation in the rates they charge, and the (short) answer is twofold.

First, expected inflation often is lower than future realized inflation, especially on an after-tax basis; this has been the experience to date with the U.S. Treasury Inflation Protected Securities (TIPS) market. Second, in a world with a small number of extremely liquid creditors — Chinese exporters, OPEC states with current-account surpluses, etc. — and with aging populations in key countries, the marginal lender often is willing to accept a lower rate in exchange for the safety of government bonds.

A second reason the BOJ regards non-zero inflation as optimal is a concept most of us forget about after Economics 101 — the demand for cash balances. If inflation induces preemptive buying, or the conversion of cash into assets before the cash depreciates further, deflation does the opposite. Savers are rewarded both for holding on to cash and by cheaper prices tomorrow. Think of your own experiences in consumer electronics: You know whatever you buy today you will be able to buy for less tomorrow.

That incentive, spread across an entire economy, encourages savings over consumption and makes low nominal interest rates completely ineffective as a tool of economic stimulus.

Despite the recent dollar/yen volatility, the pair has remained within a roughly 118.00/112.00 range since late August (Figure 1). With the yen remaining captive to the whims of global carry trade players, movement in the Japanese currency will remain dependent on overall levels of market volatility and global risk appetites.

For now, currency strategists agree that economic and political fundamentals will have little impact on the overall action of the Japanese currency.

“It looks like we’ve shifted into a 113-118 range,” says Thomson FX Hub’s Coleman. “And 118 has become a formidable barrier. I’d be selling rallies in dollar/yen and euro/yen.”

Forex.com’s Dolan has been monitoring the CBOE Volatility Index’s (VIX) correlation with the yen carry trade (Figure 2).

“The VIX had been averaging around 12-15 in June [as dollar/yen was rallying into the 124 region],” he says. “At the peak of the market turmoil in August, the VIX soared to 37.5 as yen carries were dropped.”

In early October, as volatility retreated, the VIX dropped back to the 15-18 region. However, on Oct. 19, the VIX had surged above 22 when the U.S. stock market turned sharply lower.

Dolan suggests forex traders monitor the VIX as a potential timing tool for yen carry trades.

“On moves above 18-20 in the VIX, it might not be a good thing to be looking at the yen carry trade,” he says. “It is very much a real-time situation. If you’re trading the yen, you’ve got to be watching the equity markets.”

Implied volatility in three-month dollar/yen options is another measure forex traders could monitor. Ideaglobal’s Powell has been watching this indicator in recent weeks, noting a recent summer implied volatility low at 6.7 on July 20. However, in mid- August, as the dollar/yen pair retreated below 112.00, implied volatility soared to 14.9. As of Oct. 18, implied volatility stood at 9.1.

“We are still in a period of elevated volatility, although it has calmed down from the August peak,” Powell says.

Forex traders are well aware that low volatility is ideal for successful carry trades. Otherwise, price spikes can wipe out the profits from bullish interest rate differentials.

“We expect volatility to remain elevated between now and year-end, which should keep the dollar/yen below 120.00,” Powell says.

Ideaglobal forecasts the dollar/yen at 112.00 at the end of 2007, and at 110.00 at the end of the first quarter 2008.

“If there is further turbulence in U.S. equity markets it would not be a good time to be long the dollar/yen,” Powell notes.

The start of the fourth quarter has been volatile for the Japanese yen (JPY). Japan’s currency swung up and down in the weeks following a change of the Japanese political guard with a new Prime Minister Sept. 26, a fresh plunge in U.S. equity prices in mid-October, and ongoing portfolio adjustments in relation to global carry trade positions (Figure 1).

Fresh concerns about the U.S. economy, centered around housing market woes, helped trigger the October equity sell-off (the 20th anniversary of the October 1987 crash might have played a part, too), which in turn decreased global investors’ appetite for risk — again — and helped drive the yen higher vs. the dollar. It’s like seeing reruns of your favorite television episode. When risk appetite in the global investment community rises, players move back into the carry trade, selling yen and buying riskier, highyielding assets. A decrease in risk appetite, however, sparks an unwinding these positions, which ultimately boosts the yen.

The Japanese yen (JPY) used to be the favorite whipping boy of the protectionists, especially in the auto industry. The yen shot higher during the 80s stock-and-land bubble in Japan, and its weights in U.S. imports began a decline still underway (Figure 2). When the yen more than doubled against the dollar, Japanese goods did become more expensive. They were replaced (as will be explained next month) either by cheaper exports from sources such as China and other Asian exporters or from Mexico or by Japanese goods made outside of Japan, principally in Mexico and the U.S.

The weaker dollar did nothing to increase export weights to Japan, which peaked in the early 90s and have fallen ever since. Much of this is due, of course, to Japan’s Lost Decade, now in its 17th year by some measures. The rest is attributable to various non-price trade barriers in Japan and to the availability of cheaper goods from Asian sources.

The yen had been rising from ¥201 to the dollar at yearend 1985, consistent with high and rising current account surpluses. It peaked at 122 in November 1988. But throughout the course of 1989, the yen steadily weakened to 158.20 by April of 1990. There were good reasons to shun the yen. The Japanese banking system was coming apart at the seams, with banks failing left and right and corporate bankruptcies in the thousands every month.

The government had emergency spending plans in place to try to goose the recessionary economy, but the economy didn’t respond.

This is when we heard Keynes being cited, as in, “You can’t push on string.” It was as close to a 1930s-style Depression as any country has come since. The Nikkei had already started falling in 1989 from over 40,000 to an intermediate low of 13,019 in October 1998 (it didn’t bottom until 2003). Everyone complained about the weakening yen, including the U.S.

During this period, the S&P swooned from a peak of 1,190 in July 1998 to 923 in October 1998 — 2 percent more than the proverbial 20 percent required to call a down move a “bear market.” The carry trade existed then, too. The Japanese Ministry of Finance, aided by the U.S. Treasury, intervened to drive the yen back up.

This was, in fact, the last time the Japanese intervened to raise the value of the yen. (The subsequent intervention, in 2003 and Q1 2004, which was the biggest ever by any central bank, was to drive it down. The amount then was a combined ¥35.2 trillion.)

In 1997-98, the world financial crisis was triggered by excess liquidity, asset bubbles, and undervalued currencies in emerging markets. Starting in Thailand and moving around the world to other emerging markets such as Brazil and Russia, asset prices fell through the floor. The culmination of the crisis was the failure of the hedge fund Long-Term Capital Management and its Fed-sponsored bailout.

The collapse of the yen carry trade was an accidental byproduct of all this. It started when one fund, Julian Robertson’s Tiger Management, blew up in early October 1998 . The yen rose from 135.64 on Oct. 5, 1998 to 114.32 on Oct. 19 — a net change of almost 22 points in 14 days. Every day the yen moved up several big figures as additional carry traders exited. The BIS is afraid of a replay of this debacle, even though in 1998 the yen was simply an innocent bystander.

The BIS report also mentions the possibility of another global meltdown arising from the U.S. sub-prime mortgage problem, which has so far caused grief and gnashing of teeth at Bear Stearns and the failure or takeover of some 60 lesser mortgage providers — but no big-institution failures and (so far) no domino effect. The point (for the forex market) is not whether the U.S. sub-prime market is going to crash, but whether it inspires fresh risk aversion. Overall, general risk aversion is assumed to include aversion to the yen carry trade.

It remains to be seen whether that is a valid assumption. No one disputes that risk aversion is too low. The JP Morgan index of emerging market bonds showed a 14-percent spread over Treasuries in 1999, and was at 1.56 percent on June 26.

Perhaps in 1999 traders were overly risk-averse, but 1.56 percent sounds too low. The Japanese Ministry of Finance is taking an unusually aggressive stance with its policy switch. At a guess, it doesn’t want to be blamed for a replay of 1998 now that the BIS, International Monetary Fund, and many other authorities are pointing a finger at it.

In fact, with deflationary conditions still in place in Japan despite good growth, it is perhaps taking a noble risk for the good of the world rather than its own immediate self-interest. Notice that the Bank of Japan (BOJ) is being left out of things so far.

The obvious solution to the wide yield differential is to raise interest rates. Technically the BOJ is independent and can resist government pleas for higher rates, which leaves intervention (verbal or cash) the only tool at Japan’s disposal.

We should probably assume that Japan wants to avert a world crisis by inching the yen up instead of having hedge funds exit the carry trade in a panic, causing a move similar to the 1998 rush for the exits.

A more gradual dollar drop/yen rise — a 45-degree slope rather than a 90- degree one — puts the yen at the desired level around ¥101 two years from now, in June 2009. But as we all know, this is not how markets work. They work in a far choppier and violent way.

If this policy change is the real deal, the Japanese (and presumably others) are going to have to intervene most judiciously — after all, the yield advantage still exists. The big question is whether there is a big firm out there like Robertson’s Tiger Fund that will take away their latitude of action and jump the gun on carry-trade unwinding.

An equally big problem is if the yen starts rising, the dollar will be on the ropes against everything. We will hear again about all those tiresome pseudo-issues such as the current account deficit and reserve diversification. Still, a rise in the yen is a fall in the dollar, whatever it means. The market has more money than the Bank of Japan, even if combined with other central banks.

We should not expect a sharp rise in the yen anytime soon. But the risk of a yen short position — with the trend and with the logic of yield differentials — is now much, much higher.

Another “reason” behind the yen’s rise is the widely expected Bank of Japan (BOJ) rate hike in September or October, although possibly as early as August. This argument really doesn’t hold water. A rate hike would still leave a very large gulf between Japanese and foreign paper, although we can admit that if the famously reticent BOJ were to raise rates in the absence of inflationary pressure in the name of “normalization” and a nod to superior growth, then we need to pay attention; more hikes will be on the way. This is a tremendously contentious issue: Under what circumstances should a central bank, facing zero inflation, raise rates?

One answer is that Japan has failed to become a global financial center on par with New York or London, but has not abandoned the objective. Japan has the world’s second-largest economy but Tokyo is not the world’s second largest financial center. In fact, Tokyo has lost rank over the past 15 years. The Tokyo Stock Exchange is the world’s second-largest after the New York Stock Exchange, but its capitalization is only 10 percent of world capitalization, even as emerging markets rocket higher. It had one-third of world capitalization in 1990.

Foreigners don’t want to list their companies in Tokyo, with only 25 listing last year, from 125 the year before. New York, even with the deterrent of Sarbanes-Oxley rules, attracted more than 440 in 2006. Worse, in recent years the Tokyo Stock Exchange has had some huge technology failures that shut down trading for entire days. Despite being the land of electronics, the exchange is considered technologically deficient. Singapore and Hong Kong, with tiny economies, are bigger and more dynamic — and associated by language, history, and culture with China, which is rapidly displacing Germany as the third largest economy.

The first study group on enhancing Japan’s position as an international financial center was held in 2003, but it seems to be new FSA chief Yamamoto who is reviving the initiative. He adheres to the belief that you can’t be a major world financial center with a falling currency that fails to reflect good economic fundamentals, which in Japan’s case is the highest growth rate in the world in 2006. However, wishing to be a world financial center is not the same thing as knowing how to get there.

Is it even remotely reasonable to assume that engineering a stronger yen can be viewed as a prerequisite to this goal, and let’s worry about the rest of the components of becoming a world center later on? Yes. It is exactly the kind of straight-line thinking we have seen from Japan in the past — and oddly, it often succeeds.

Working on becoming a world financial center could remain an objective of whatever government is in office, and Prime Minister Shinzo Abe and his coalition government risk losing power in the July 29 elections. Even if Yamamoto does not remain the FSA chief, the next guy would be bound by the overarching government objective. Japan has a splendid history of longterm planning. The next FSA head will pick up the internationalization effort where Yamamoto left off.
Having a stronger currency based in part on gher interest rates is not the only obstacle Yamamoto faces in trying to make Tokyo a global financial center. He also has to overcome a penchant for regulatory red tape that stifles innovation and encourages people to find ways around regulatory agencies (including the FSA itself) instead of simply asking for exceptions and help.Most observers say the biggest problems are cultural. To be an international center, you have to attract foreigners to live and work in Tokyo.

But the language is difficult to learn and has complex nuances — the word for “risk” didn’t exist in Japanese, and comes from English. Women are second- rate citizens and not represented at executive levels, a waste of half the manpower of the country.

Japan has its fair share of smart people, but arguing and disagreeing with others is socially unacceptable. It makes brainstorming particularly difficult. And respect for older people, while laudable, restrains brash youngsters from making a splash. But splashiness and disorder are what you need to sponsor change.

But a real problem with going long the yen is that it’s difficult to understand the reasons behind the currency’s rise. Typically, when a trend reversal occurs you can identify the sentiment shift as it is occurring and know what’s coming at least a few days in advance. This time there’s a full plate of “reasons” for the reversal, but none of them are compelling. Even taken as a whole they are not particularly powerful. Besides, the countervailing reasons for the yen to remain in its primary downtrend have not gone away.

Let’s look at the reasons we can comfort ourselves with as we buy yen. First, there was a serious policy shift at the Japanese Ministry of Finance in late June (see “The hammer and the yen”). The government simply no longer sees a weak yen as acceptable. Not only is the government worried about pressure from other countries, notably France, but a weak yen makes energy and commodities expensive in yen terms, which is a negative for small and medium-sized firms, including many exporters. Sony, Honda, and the other big names are experienced hedgers (and cost-cutters), but smaller firms suffer.

It’s wise to respect a stated policy shift such as this because governments can be powerful influences,althoughwe hardly ever see the influence atwork. It’s done behind the scenesusing what is euphemistically called “moral suasion.” In a phone call, over drinks, or at the golf course, an official makes a gentle suggestion to a banker or broker, (“…and Bob’s your uncle”), and the disliked behavior stops instantly. Governments regulate banks and brokers, plus they tax everybody. You disobey a government official’s suggestion at your peril. And in Japan, respect for authority runs high.

There are numerous ways the government could nudge institutions away from a weaker yen. Japanese retail investors are avidly pursuing accounts denominated in other currencies, for example, but that would tend not to be the focus. Instead, attention would likely turn to cutting lines of credit to speculators, chiefly hedge funds, especially if they invested in U.S. sub-prime paper. This would kill two birds with one stone — halting an outflow from yen and reducing exposure to high-risk paper.

The sub-prime housing problem in the U.S. has already hit a number of hedge funds, the main players in the carry trade. An Australian hedge fund hired Blackstone to advise it on subprime investments, and immediately everyone suspects these investments were made with borrowed yen. We don’t know that for a fact, but the mere suspicion suffices to goad some traders into imagining that if there is one firm doing this, there might be dozens.

As far as we know, no hedge fund using borrowed yen to invest in U.S. sub-prime has actually gone under, and we do not know if the sub-prime problem is going to contaminate other collateralized debt funds to the point of failure. But from the hysteria in the blogosphere, you’d think widespread institutional failure is imminent. Nearly all hedge funds are non- Japanese, but if Japanese banks are providing the funding, they are at risk, too.

Japan has no intention of letting its banks fall victim to dud loans to such institutions — or forex trades, either. Presumably, lending to hedge funds has been curtailed, along with credit lines for simple position- aking trading. As for lending to domestic Japanese funds, Japan’s nine biggest banking groups have more than ¥1 trillion ($8.3 billion) in various instruments backed by U.S. sub-prime mortgages, according to the JiJi newswire.

In late July, Financial Services Agency (FSA) chief Yuji Yamamoto told the press the government is closely monitoring Japanese financial institution risk-management practices. The FSA finds the banks “well-prepared.” Considering the entire banking sector was in the tank only 10 years ago and survived only with massive government bailouts, we wonder whether this can be true, but never mind. We should probably assume that Yamamoto told the banks to stop investing in the sector and perhaps even to dump some of the paper. Such trades are, in effect, repatriation, and automatically entail buying yen.

This presupposes the Japanese institutions do not just switch to betterquality foreign paper. After all, the yield differential is still vastly in the favor of the Australian dollar, New Zealand dollar, British pound, euro, and U.S. dollar. If the Japanese government were asking its financial institutions to forego that additional yield, it would be a shocking interference with private business. (That doesn’t mean they wouldn’t do it.)

Last month’s article (“The hammer and the yen,” Currency Trader, July 2007) discussed a potential trend reversal in the Japanese yen (JPY) that is developing the way we feared. So far the yen has risen about 4.00 points from the June 22 low at 124.15, and no matter what indicator you draw on the chart, it’s a clear reversal.

The yen staged a breakout over the standard error channel drawn from the March yen high. The current price is well over the red 20-day moving average and less than 100 points from the green 200-day moving average — the latter usually considered the “long-term” average that often acts as resistance, like the channel top. Price has also surpassed the previous highest high from early June (gold horizontal line).

It’s interesting that on the basis of the relative strength index (RSI) and the stochastic oscillator, two indicators used to signify overbought or oversold (not shown), the yen is still “weak” and hasn’t even headed up toward the overbought level. This implies the up move may have a long way to go.

Drawing the standard error channel starting farther back in time (from the May 2006 high of 109.00) shows the current move’s trendline would meet the upper boundary of the channel at 119.50 sometime around Aug. 20 if it continues at the same slope (Figure 2). This perspective of the channel shows the current yen move to be only a secondary correction of the bigger primary down move. This is probably the correct interpretation, but it doesn’t pass the “So what?” test if you are trying to trade the yen. The bottom line is, if you are trading the yen, you have to be long.