A fightback from the Samurai?

If there has been a symbol which represents Japan, it is the medieval Samurai. I have cited the exmaple of a Samurai, as i believe the Japanese yen has the potential to stage a fightback against major currencies, most notably the US Dollar.

The Yen is a currency which has always been very attractive from the view of a carry trade i.e. borrowing money in Japan converting it to Dollars and investing it in the US. The trade is settled by reversing the sequence of transactions. The interest rate differentials between the two countries made this a very lucrative trade, as Japan is one of the few countries where real interest rates are negative. Interest rates in the US were much higher, which increased the lure of the "carry trade". Well things are changing now. The interest rate differential between the two countries is much narrower, as the US Federal Reserve has cut interest rates aggressively. Trades which were entered into earlier are no longer as attractive, in fact would'nt be wrong to say are a loss making proposition presently due to the shift in interest rates.

The imminent reversal of carry trades is likely to lead to a stronger Yen, which ironically isnt in Japan's interest as the country is an export oriented economy. Another important fall out is, Japan has been one of the favored destinations to borrow loans taking yen denominated loans will become more difficult. This will reduce the amount of capital flowing from Japan into global financial markets.

I believe we could witness a sharp rally in the Yen. Markets have a tendency to surprise, the rally in the US Dollar through most of 2008 being a prime example. Given the problems the US experiences in terms of its current account deficit and labor market, it is difficult to believe the rally in the US Dollar will sustain over the next 9-12 months. In the present markets getting the direction right is a herculean task by itself, getting the timing right would be impossible.

A rally in the Yen is potentially the surprise trade of 2009, I believe there is a possibility the rally might last longer than expected. My thoughts have already started to drift to 2009, as i await the end of what has been a tumultous, crazy and a very eventful year.