Trading the U.S. Dollar/Japanese Yen
The U.S. dollar/Japanese yen pair features low bid-ask spreads and exceptional liquidity. As such, it is a great pair to trade for newcomers to the forex market as well as an old favorite for more experienced traders. And thanks to the forex market's 24 hour trading day, U.S.-based traders who prefer to trade at night should consider focusing on the U.S. dollar/yen because the yen is heavily traded during Asian business hours. (For more insight, see In the forex market, how is the closing price of a currency pair determined?)
As previously mentioned, selling the yen as part of the carry trade is a popular strategy. The popularity of the yen carry trade depends greatly on the state of the global financial markets. When there are loads of opportunities to be had in global financial markets and volatility is relatively low, traders view the yen carry trade as a good way to make money. However, when volatility increases,, the yen carry trade tends to decline in popularity. A good thing for forex traders to look for when unsure of global volatility is the popularity of the yen carry trade amongst hedge funds and other institutional investors. During relatively quiet periods, the carry trade is very popular, and the ensuing selling pressure will typically cause the yen to weaken. When global market volatility increases, the popularity of the yen carry trade diminishes. As traders reverse the carry trade, they must then purchase the yen. This buying pressure will lead to a general appreciation in the yen relative to the U.S. dollar or other currencies.
Another big factor to be conscious of with the yen is Japan's dependence upon imports and exports. Since Japan is largely dependent on imported oil and other natural resources, rising commodity prices tend to hurt the Japanese economy and cause the yen to depreciate. Slower economic growth among Japan's major trading partners will also cause Japan's export-dependent economy and the yen to weaken. Japan's export dependence can also lead to central bank intervention when the yen shows strength. Although economists sometimes debate the effectiveness of central bank intervention, it's important to consider what impact they might have. The Bank of Japan has a reputation for intervening in the forex market when movements in the yen might threaten Japanese exports or economic growth. Forex traders should be fully aware of this so that they are not caught by surprise if intervention by the Bank of Japan causes a U-turn in the trend of the yen. (For related reading, check out Using Currency Correlations To Your Advantage.)
As the most liquid currency in Asia, the Japanese yen is also used as a proxy for overall Asian economic growth. When economic or financial volatility hits Asia, traders will react by buying or selling the yen as a substitute for other Asian nations whose currencies are tougher to trade.
Finally, it's important to mention that Japan has suffered an extremely long period of poor economic growth and correspondingly low interest rates. Traders need to pay careful attention to the future path of Japanese economic growth. Eventual economic recovery could bring with it increased interest rates, a decrease in the popularity of the yen carry trade, and consistently stronger levels for the Japanese yen.
Japanese Yen Facts
The Japanese economy is the leading economy in Asia and the world's second-largest national economy. Japan is a major exporter throughout the world. Because of Japan's large amount of trade with the United States, Europe, Asia and other nations, multinational corporations have a regular need to convert local currency into Japanese yen and vice versa. Consistently low interest rates in Japan have made the yen a popular currency for the carry trade as well. For these reasons, among others, the U.S. dollar/Japanese yen pair is heavily traded in the forex market.
The Japanese Economy
A relatively small country in terms of size with little in the way of natural resources, Japan has relied on a mastery of new technologies, a strong work ethic, innovative manufacturing techniques, a high national savings rate, and a close working partnership between the Japanese government and business sectors to conquer its natural disadvantages. Although the country and its economy were severely damaged during the second World War, the Japanese economy has since grown to become the largest on the planet next to the United States.
However, following over 40 years of incredible economic growth, the early 1990s marked an end to the Japanese bull markets in domestic equities and real estate. The bursting of these bubbles led to a quick economic slowdown and a deflationary spiral. The Japanese banking system was left with trillions of yen in bad loans and consequently cut back its lending activities. Japanese consumer spending also slowed dramatically as the country entered a prolonged economic downturn. For two decades, the Japanese government has struggled to revive the economy and return growth to its previously robust rates. Although t efforts have not yet been completely successful, no one can argue the fact that Japan has become an economic powerhouse and an important source of global economic activity today. (For background reading, see The Lost Decade: Lessons From Japan's Real Estate Crisis and Crashes: The Asian Crisis.)
The Japanese Yen
The Japanese yen is the most heavily traded currency in Asia and the fourth most actively traded currency in the world. During the 1980s, some analysts felt that the yen would one day join the U.S. dollar as one of the world's reserve currencies. Japan's extended economic decline put a stop to those hopes, at least temporarily, but the yen remains an extremely important currency in the global financial markets. (Find out how yen carry trades contributed to the credit crisis in The Credit Crisis And The Carry Trade.)
The primary outcome of Japan's extended period of sluggish economic expansion is that the Japanese central bank has been forced to keep its interest rates very low to help encourage economic growth. As we previously touched on, these reduced interest rates have made the Japanese yen tremendously popular in the carry trade. In a carry trade, investors and speculators sell the yen and use the proceeds to purchase higher yielding currencies. This constant selling of the yen has played a part in keeping it a lower level than it might otherwise trade.