Japan’s doing well – so why is the yen plummeting?

What's wrong with the yen? With the Japan's economy finally showing signs of life, the stockmarket up over 30% year-to-date, and the bank of Japan hinting it may soon tighten its famously loose monetary policy, you'd think the currency would be soaring.

But it isn't. Instead, it's fallen 18% against the dollar this year (there are now 121 yen to the dollar) and is currently at a seven-year low against the euro.

This isn't as surprising as it sounds, says Steven Johnson in the FT. The same happened in 1985 when, despite the fact that the Nikkei "was well on its way to its 39,000 peak", the yen collapsed to 260 to the dollar. It seems that when the Japanese economy is on a roll, Japanese risk aversion falls, and as a result Japan's investors move more money into foreign markets to bump up the yield on their investments (Japan still has zero interest rates). The bulk of this yield-chasing cash has headed to the US, where Japanese investors can now get 4.27% more from a one-year US bond than they can from a one-year Japanese bond.

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The yen's ongoing weakness has encouraged foreign investors to hedge their currency exposure to the Japanese stockmarket. As the yen buys less pounds or dollars, they lose out when repatriating equity gains, which hedging can prevent. This in turn pushes the yen down further, making the whole thing rather circular.

But don't count on the yen staying a one-way bet, says Capital Economics analyst Julian Jessop. There are several reasons to think that the yen will turn around in 2006. For starters, if the US really does slow next year (which it increasingly seems it will), Japan is likely to be seen as a safe haven as its stock market recovery is geared to the domestic, not the global, economy.

The current weakness of the yen should also bring imported inflation with it, hastening the end of deflation and suggesting that we might see monetary policy tighten sooner than many think. Finally, note that so many speculators are now short the yen that there is room for the yen to firm up fast if the tide turns and they all have to buy yen to close their positions.