Japan’s Currency Woes: Yen ETFs in Focus

With just two and a half months in the books, 2010 has already been an odd year from an investment perspective. A small European nation that accounts for just a fraction of global GDP has become a major driver of stock and bond markets around the globe, capable of setting off both buying and selling sprees with every new development. The financial sector, a laggard since its role in sparking the most recent recession, has surged higher, while utilities have been among the worst performers.

But perhaps no development has been more perplexing than the strength of the Japanese yen, an issue that has become a source of major frustration to officials still working to pull Japan’s economy from a prolonged downturn and ward off a period of deflation. A strong yen is a potential problem for Japan because it makes the country’s exports, a major component of the national economy, more expensive to international consumers. For the most part, Japanese equities missed out on the rally of 2009, finishing the year in positive territory but lagging far behind emerging and developed economies. While the drivers of the country’s poor performance are numerous, the relative strength of the yen has frequently been fingered as a major contributor.

The persistently strong currency has sparked some bizarre actions from the Japanese government in recent days. “Prime Minister Yukio Hatoyama tried to weaken the yen Friday through the unusual step of talking down the Japanese economy in front of parliament,” writes Alex Frangos. “He called for international help to contain the yen’s advance.” According to Frangos, the yen is nearly 20% stronger than it was in August 2008 compared to an inflation-adjusted basket of currencies weighted towards Japan’s largest trade partners.

Reversing Course?

Identifying a primary cause of the yen’s resurgence is a challenging task. While interest rates in Japan are near zero, record low rates elsewhere provide little incentive for investors to switch to other currencies. Moreover, a new tax law is encouraging Japanese corporations to repatriate foreign earnings, and is expected to result in companies bringing nearly $5.5 billion home in March.

Despite the government’s inability to suppress the Japanese currency in recent months, signs that the yen may be due for a reversal are beginning to emerge. The Bank of Japan will reportedly increase the money supply at its meeting this week, a step that could help to fight deflation. More importantly perhaps is the potential return of the carry trade, the practice of borrowing yen to invest in higher-yielding currencies. Australia has already begun raising interest rates, and expectations for a rate hike in the U.S. at some point this year have jumped in recent weeks. Numbers from the Tokyo Stock Exchange indicate that investors are betting on a slide in the yen.

Yen ETF Options

For investors looking to take either a long or short position in the yen, there are a number of options available.

• CurrencyShares Japanese Yen Trust (FXY): This ETF is designed to track the performance of the Japanese yen, and is structured as a equitized single currency trust. As shown below, FXY has been relatively volatile in recent months as Japanese officials have stepped up their efforts to hold the currency in check.

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• WisdomTree Dreyfus Japanese Yen Fund (JYF): While currency ETF products from WisdomTree and Rydex will generally exhibit strong correlations, there are some key differences between these funds that may impact effective tax rates and exposure to credit risk. JYF is up nearly 8% over the last year, including a 3% gain so far in 2010.

• ProShares UltraShort Yen (YCS): This ETF has slipped in 2010 as the yen has shown strength, but could be an interesting play for investors convinced that the government’s efforts to suppress the currency will ultimately be successful. It should be noted that YCS seeks to deliver leveraged results on a daily basis, meaning that regular monitoring and rebalancing may be required if holding over an extended period of time.

Disclosure: No positions at time of writing.