The Japanese yen has the enviable quality of going zig when global markets go zag. So in the past few weeks, the Japanese yen has resumed its upward move against all major global currencies, including the British pound sterling, the euro, and the Australian dollar. Consider that on the very day Lehman Brothers announced its bankruptcy, and the U.S. markets had their worst day since Sept. 11, the yen managed to rise 2.81% against the high-flying dollar.
Here’s why I think the yen will continue to rise even as turbulence in global markets continues.
First, 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 is a thing of the past. With returns falling in all asset classes, yen borrowing will inevitably diminish. In the midst of a credit crunch, banks are tightening up their lending practices. And as hedge funds face heavy redemptions, the yen “carry trade” will continue to be unwound even further.
Second, increased volatility in global financial markets means that a growing number of traders will be forced to close out highly leveraged yen financed positions by buying more yen — putting sustained upward pressure on the Japanese currency. Sharp moves in the yen during periods of global market turmoil are hardly new. When hedge funds unwound their yen-financed positions after Russia’s default on its government debt in 1998, the yen skyrocketed by 20% in two months. Later that October, when the Japanese government announced a plan to re-capitalize its crippled banks, the yen jumped another 13% within three days. Hedge funds suffered punishing losses.
Third, its recent rise notwithstanding, 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. An unintended result has been that the yen has become remarkably undervalued compared with other global currencies. According to the Financial Times, the yen hasn’t been this cheap since the mid 1980’s. The Economist‘s Big Mac Index says the yen is undervalued by 27%.
So buy the CurrencyShares Japanese Yen Trust (FXY) and place your stop at $89.25. This exchange-traded fund is unleveraged, so you can take a relatively large position in it. 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 U.S. dollar versus Japanese yen exchange rate, it also acts as a hedge against any unexpected weakness in the U.S. dollar.
With last week’s astonishing volatility, you were stopped out of the Market Vectors Double Short Euro ETN (DRR) for a slight loss. I’ll be keeping an eye on this position to see when we can get back into it. Keep an eye on the Direxion Funds Dollar Bull 2.5x Fund (DXDBX), which is near its stop price as well. The S&P Biotech ETF (XBI) proved remarkably resilient for such a volatile sector.
Otherwise, make sure you stick to your stops in this unpredictable market environment.
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