Intro to Trading the Japanese Yen

09/23/2011 6:00 am EST

Focus: FOREX

The yen stands alongside the world’s most significant currencies, yet several unique factors related to Japan’s economy, monetary policy, and political structure weigh heavily on how it is traded.

Just seven currencies account for 80% of the forex market, and the Japanese yen (JPY) is one of the largest currencies in terms of international trade and forex trading. That is only fitting, as Japan is one of the largest economies in the world, with the third-highest GDP among nations and the fourth-largest exporter in dollar terms.

All of the major currencies in the forex market have central banks behind them. In the case of the Japanese yen, that is the Bank of Japan (BOJ). Like most developed-country central banks, the Bank of Japan has a mandate to act in a fashion that encourages growth and minimizes inflation.

In the case of Japan, however, deflation has been a persistent threat for many years, and the BOJ has pursued a policy of very low rates in hopes of stimulating demand and economic growth. At various points in the 2000’s, real rates in Japan were actually slightly negative.

The Economy Behind the Yen

The Japanese economy has some particular and peculiar attributes that yen traders need to understand.

Despite its size, Japan has been notably lacking in growth since the collapse of its real estate bubble. Writers often refer to a "lost decade" in Japan, and though that may not be entirely accurate, growth has rarely exceeded 2% between 2001 and 2011, and has contracted to zero or negative rates multiple times.

Japan is also notable for inflation, or rather its almost near-absence of it. Japan has actually experienced deflation for much of the last decade.

Japan is also the oldest major economy in the world and has one of the lowest fertility rates. That suggests an increasingly aging workforce with fewer and fewer younger workers to support the economy through taxation and consumption. Japan is also quite closed to immigration, and that establishes difficult demographics.

Japan is an advanced economy with a well-educated workforce. Although industries like shipbuilding have migrated to countries like South Korea and China, Japan is still a leading manufacturer of consumer electronics, autos, and technological components. This has left Japan with significant exposure to the global economy, but increasing reliance on China as a trade partner.

NEXT: Key Price Drivers of the Yen


Key Price Drivers of the Yen

There are several theories that attempt to explain foreign exchange rates. Purchasing power parity, interest rate parity, the Fisher Effect, and balance of payments models all offer explanations of the "right" exchange rate, based on factors like relative interest rates, price levels, and so forth.

In practice, these models do not work especially well in the real market. Real market exchange rates are determined by supply and demand, which includes a variety of market psychology factors.

Major economic data includes the release of GDP, retail sales, industrial production, inflation, and trade balances. These come out at regular intervals, and many brokers, as well as many financial information sources like The Wall Street Journal and Bloomberg make this information freely available.

Investors should also take note of information on employment, interest rates (including scheduled meetings of the central bank), and the daily news flow. Natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

In the case of Japan and yen traders, the Tankan survey is particularly noteworthy. Many countries report information on business confidence, and the Tankan is a quarterly reported published by the Bank of Japan. The Tankan is seen as a very important report that often moves trading in Japanese stock and currency. Trade flow data is also uncommonly important for the yen.

The Yen Carry Trade

In many respects, BOJ policy drives carry trades across the world. Carry trading refers to borrowing money in a low-interest-rate environment and then investing that money in higher-yielding assets from other countries. With a stated policy of near-zero interest rates, Japan has long been a major source of capital for that trade. That also means, though, that talk of higher rates in Japan can send ripples throughout the currency markets.

Unique Factors for the Japanese Yen

While the BOJ has maintained low rates since Japan's property bubble collapsed, the bank has also been involved in currency intervention—selling the yen to help keep Japanese exports more competitive. This intervention has carried political consequences in the past, though, so the BOJ is relatively hesitant to intervene in the forex markets relative to its past history.

Japan's trade balance also impacts BOJ policy and forex rates. Japan has large trade surpluses, but very large public debt and an aging population. A large percentage of that debt is held domestically, though, and Japanese investors seem willing to accept low rates of returns.

Japan is the signature currency for Asia; it is the third-most-frequently traded currency in the world, and a significant secondary reserve currency for many Asian countries. While the significance of the yen could be at risk if the Chinese yuan becomes more liquid, that would likely be a multi-year process.

That said, the relative stability of the yen has made it a backup reserve currency for many countries. While Japan has very high debt levels, traders tend to be more comfortable with Japan's debt balance, as so much of it is domestically owned.

Moreover, traders often balance the high debt level of Japan with its high trade surplus, though the devaluation of the dollar and the "safe-haven" status of the yen have led to a stronger yen, which threatens the very trade surplus that makes the yen attractive.

The Bottom Line

Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods of time. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.

Japan's strong trade surplus will likely maintain the country's position as a relative safe haven for some time to come, but the aging workforce, persistently low consumer and business confidence, and the rising significance of China as an economic rival do threaten that position.

By Stephen D. Simpson, contributor,

Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell- and buy-side investment companies in equities and fixed income. Stephen's consulting work has focused primarily upon the health care sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and health care. Simpson operates the Kratisto Investing blog.
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