A Yen for Safety

09/23/2008 12:00 am EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Vardy’s Global Stock Investor, says the unwinding of the speculative “carry trade” makes a Japanese yen ETF attractive.

Much of the Japanese yen’s recent appreciation reflects investors cutting back their borrowings in yen to fund investments in higher-risk countries and currencies—or what has been called the unwinding of the “carry trade.”

The “carry trade” has been a license for global traders to print money during the past few years. With Japanese interest rates at 0.5% and interest rates in Europe at 4%, traders borrowed billions in yen and invested billions, leveraged up, into assets priced in higher-yielding currencies.

By artificially pumping up global liquidity, the carry trade helped inflate asset-price bubbles across the world. Now those positions are being reversed as investments are liquidated across a wide range of asset classes and regions.

The Japanese yen already has appreciated about 15% during the last 18 months. Here’s why I think the yen will continue to rise and offer you a safe-haven investment during uncertain times in global stock markets.

First, the Japanese yen remains the most undervalued currency of a developed economy in the world. Since the collapse of the Japanese asset bubble in the late 1980s, the Bank of Japan has pursued an extremely low interest rate policy to kick-start the Japanese economy.

The only currency more undervalued is the Chinese yuan, [which I also recommend] through the WisdomTree Dreyfus Chinese Yuan Fund (NYSEArca: CYB). On a purchasing-power-parity basis, there still is significant upside for both the Japanese yen and the Chinese yuan.

Second, with an overall jump in global risk aversion, the days of hedge funds using the yen as a cheap source of capital to invest in riskier assets are a thing of the past. And in the midst of a credit crunch, banks are also tightening up their lending practices. Big speculators simply won’t get the borrowing power to do the carry trade in the size they need to make big profits. And as hedge funds face heavy redemptions, carry trades will have to be unwound even further.

Third, the increased volatility in financial markets means that many traders will be forced to close out highly leveraged yen-financed positions by buying more yen. Sharp moves in the yen during periods of global market turmoil are typical.

So, buy the Currency Shares Japanese Yen Trust (NYSEArca: FXY) and place your stop at $89.50. (It closed at $95 Monday—Editor.) As with the Chinese yuan, it’s best to think of the Japanese yen as a “cash-plus” investment with solid potential upside even as global markets continue to fall out of bed. Because this ETF follows the US dollar versus the Japanese yen, it also acts as a hedge against any unexpected weakness in the US dollar.

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