Tokyo reported terrible GDP numbers a few weeks back. The U.S. dollar was spurred by this report, moving 5 whole cents, from 93 and 1/2 to 98 and 3/4. But believe it or not, the news is still working magic in the market.
In short, it initiated a new change in currency relationships. Up until this point in the last several months, any time the U.S. dollar weakened against the pound or euro, it strengthened against the yen, and vice versa. Now the U.S. dollar is taking on all challengers. All three of the other majors weakened together, while the U.S. dollar went on to make new credit crisis highs. Hot Stocks
However, on Friday of last week, it appeared that the old correlations may have been coming back. The end of the week brought U.S. dollar weakness against the yen, but strength against the euro and pound.
So let's look at the skinny on this dollar/yen relationship a bit more.
It wasn't just last week that brought about a revival in the yen's weakness. Since Jan. 21, the yen has lost 12% against the greenback. That's in only five weeks... a pretty substantial move. On the technical side we saw it put in the infamous double bottom formation. It has moved steadily in favor of the dollar ever since.
The question in my mind is this: While Japan's GDP number was deplorable, it wasn't entirely unexpected, was it? It came at the end of a long line of bad news. Consider that industrial output fell 8.5% in November, 9.8% in December and then 10% in January. Exports dropped a whopping 45% in the last year. Many pundits bemoan the U.S. plight of being a non-manufacturing economy, but Japan's numbers show that manufacturing economies are faring no better than service economies.
But in spite of all this bad news, how has Japan's currency continued its stellar rise, and why now does it appear to be reversing? Have the fundamentals become just too bad to ignore? Or is something else afoot?
Currencies do not rise and fall on the sheer strength or weakness inherent in them or in their economies. They rise and fall because of the factors of supply and demand. The yen was not appreciating because it was the strongest or the surest or the safest. It was driven to these levels simply because the money flows from the long-held carry trade absolutely overwhelmed the market's ability to distribute them quickly enough. Best Stock Investing
In other words, for years, a popular trade was to borrow yen and use them to buy just about any other currency. Since the yen had an official interest rate of zero, traders could borrow them practically for free. Then they'd use the yen to buy a currency producing a higher rate of interest. The profit came from the appreciation of other currencies against the yen, as well as in the form of the interest rate differential. This is what is commonly called the yen carry, or the carry trade.
Its simplicity made it exceptionally valuable. How could you go wrong? If you can get something for free, and then sell it at any price, you will always make a profit.
But when the housing crisis began to unfold, followed by the credit crunch, traders began to worry that their high-paying interest rate differentials might be in serious trouble. What if the high-paying currency they were holding defaulted? What if the banks started cutting interest rates and they could no longer get that primo return? What if pigs started flying? What if? What if? What if?
And so, the panic began. and traders began "unwinding" (getting out of) their carry positions.
What did this do to the yen?
As you know, all currencies are traded in pairs. That is, you sell one currency then buy another. For the years of the successful carry trade, traders sold the yen to buy other money. In doing so, the yen became less and less valuable the more it was sold. Japan, as an exporting manufacturing economy, was perfectly content for it to be so, as it made their goods cheaper for the rest of the world to buy.
But when panic and fear gripped the market, and traders started to get out of their carry positions, it meant that they were selling everything else and buying back the yen. More buyers meant fewer yen. More demand on less yen meant higher prices. So the yen began appreciating like a rocket, especially against the dollar.
Was it fundamentally more sound? Was it an interest rate acceleration that propelled it? Not at all.
Just as there was no real reason for the U.S. dollar to be at 123.50 during the middle of 2007, there was also no economic rationale for the yen to be at 88.00 either.
As the world was flooded with euros, pounds, Aussies and kiwis, the yen was forced higher and higher. The money flows were essentially a one- way street, and the yen could only go in a single direction: up. Top Stocks Market
But now that the vast majority of these trades are unwound, and the money flows are subsiding in this trade, the fundamentals are again reasserting themselves.
Japan's economic condition is considerably weaker than that of the United States, and it appears that there is little the country can do about it. Printing money has not worked in the past, and it is not likely to start working now. Perhaps world demand for their goods will increase. It is doubtful, but even so, there is nothing that they can do to alter that factor either. Finally, in a world where no one is buying, trying to change from a manufacturing/exporting economy to an economy that favors domestic consumption does not happen overnight.
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