Japan Will Likely Back the U.S. Dollar Again

Includes: FXY, UDN, UUP, YCS
by: Bob Rubin

Your equity trades are affected by currency exchange rates. Here is why:

The industrial countries all rely on foreign trade for increasing shares of their GDP. For example, the OECD (Organization for Economic Co-operation and Development) reports that in 2005, foreign trade was 50.7% of the European Union countries’ GDP. The CIA, in its World Factbook, reports that 2010 exports were 23.76% of Gross World Product.

Currency exchanges make foreign trade possible. When one country sends goods to another, payment requires exchanging the currency of the buying country for that of the selling country. (The U.S. dollar has had a special role as the world’s “reserve currency.” Much foreign trade has been conducted in U.S. dollars, or has used U.S. Treasury debt for collateral.)

If a country wants more exports than imports, it helps to have a currency that is weak relative to those of its trading partners. A weak currency makes a country’s goods more affordable to foreign buyers. This is so important that the CIA reports countries with current account surpluses (countries which exported more than they imported) grew their GDPs by an average of 6.3% in 2010. Countries with current account deficits (countries which imported more than they exported) averaged just 3.4% growth.

Exports are important to Japan. Japan was the world’s second biggest exporter in 2010 ($765.2B). Only China was bigger ($1,506B). Its export business makes Japan sensitive to the yen’s position relative to other currencies, especially the U.S. dollar. The U.S. buys 16.4% of Japan’s exports, only recently exceeded by China with 18.9%.

The yen has grown stronger against the U.S. dollar since 2007. Back then, one U.S. dollar bought about 124 yen. Today, one U.S. dollar buys only about 78 yen. This 37% decline threatens Japan’s exports. Falling exports mean idle factories and unemployment. What will Japan do?

If history is any guide, the Bank of Japan will intervene in the foreign exchange market to weaken the yen against the U.S. dollar. It can do this by selling yen and buying U.S. dollars in huge amounts. Japan did this twice in 2004, weakening a surging yen. The Bank of Japan did it again September, 2010, and March of this year. Since March, the yen has continued to rise against the U.S. dollar.

Will Japan watch its foreign trade dwindle and do nothing? Unlikely. Having intervened only four months ago without getting what it wanted, the Bank of Japan will probably intervene again. There’s no way to say just when this will be, but a move against the yen and for the U.S. dollar is likely within the year.

Equity trades in ETFs tracking the yen are an opportunity. You can short the yen by selling short FXY (CurrencyShares Japanese yen Trust) or buying FXY put options (January, 2012, or even January, 2013). Another way is to buy YCS (ProShares UltraShort yen). YCS is a double-short ETF, which rises twice as much as the yen falls against the U.S. dollar. You can also buy February, 2012, calls on YCS. Shorting the yen now is an attractive long-term investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.