The Outlook For The Yen

Jul.11.12 | About: CurrencyShares Japanese (FXY)

Despite many dire proclamations about the future of Japan, with their demographic problems and high levels of debt, Japan is a safe place for investors because it has a benefit which is shared by all other developed countries which maintain their own currency. That being that save for any national debt ceiling, an unlimited amount can be borrowed to pay off debts.

Of course, taken to the extreme, serious inflation could develop. However, except for a small portion of debt, such as TIPS in the U.S. which are indexed for inflation, governments only have to pay their debts in the currency. Nothing says what they have to be worth.

While the U.S. has positive expected inflation, albeit low, Japan on the other hand has had deflation running rampant for many years now. Both countries have extremely low interest rates. Japanese short-term rates can't go below zero and long term rates should be above the short ones, due to the variable which is inherent in them that short term rates can only go up from here. So in the end Japan actually becomes a high real interest rate country.

This will push up the value of the yen as a result. Investors will flock to it both for safety and to escape low yields prevalent in the U.S. and elsewhere. One can see a correlation in recent years between market volatility and weakness with the strengthening of the yen as exemplified in the CurrencyShares Japanese Yen Trust (NYSEARCA:FXY).

FXY ChartClick to enlarge

FXY data by YCharts

To be sure, a strong yen is not where Japan wants to be economically, and calls are growing for the central bank (whom historically have been reticent to act at times) to take action to further prevent strengthening. Market actions during the second quarter of 2012 signal that most anticipated the yen to weaken. Recently, traders have increased their positions of Japanese yen futures contract to where it is now a net short substantially, which will profit should the yen weaken. I suspect part of the reason is calls for central bank intervention growing steam, but much also rests on the relative calm of the markets compared to recent years.

It is also important to note that any potential impact by the central bank of Japan can be offset because of the Fed and ECB taking their own actions, which weaken the dollar and euro against the yen. Should future U.S. growth disappoint as many suspect our stalling economy will, risk will rise, and potentially we might see the yen strengthening even more.

Short-term I see it as the primary mover of the yen. More risk and uncertainty in the market should equal a stronger yen, and a return to stability should see it weaken.

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