The 64,000-Yen Question

Has the rally run its course or is Japan's currency just getting started?
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In Asia, the debate rages about how high the yen will fly before it comes crashing down to earth -- if it does at all.

After declining throughout the year, the yen has staged a mighty comeback in recent months. Since the Japanese currency ventured to 124 vs. the dollar in July, it has strengthened nearly 12%, reaching 108.50 in New York trading on Wednesday, a 52-week high.

It's not only the weak dollar that the yen is rising against, either. In recent weeks, the yen has risen by 6% against the South African rand and Brazil's real.

One of the big arguments about the sustainability of global equity and bond prices is whether investors will resume the carry trade, and in turn bring the yen back down. Opinions in Asia differ wildly.

Sean Darby, head of strategy at Nomura Bank in Hong Kong, has been skeptical about the sustainability of the yen carry trade since October last year, when he began cautioning the bank's clients against a potential knock-on effect of a carry-trade unwinding.

With the yen carry trade, global investors such as the big financial institutions and hedge funds borrow from the Bank of Japan at 0.5% interest rates and invest elsewhere for higher yields.

The practice has contributed to the massive gains in equities in Hong Kong, South Africa and Brazil this year as cheap Japanese debt has buoyed foreign share buying in local markets.

Darby says that there are three factors contributing to a carry trade unwinding, none of which look like they will reverse anytime soon. The first is that as investors steer clear from high-yield credit market debt on recent subprime jitters, the Bank of Japan is unlikely to be used as frequently at it was before August as a borrowing source.

Secondly, with the

Federal Reserve

and dollar-pegged countries and states like Hong Kong and Saudi Arabia cutting interest rates, there is less incentive to take advantage of the differential between rates in Japan and elsewhere.

"There is a 100% chance that rates will be cut, according to the Fed futures market," says Darby. "People borrowing in yen are getting the incentive to move money elsewhere."

Lastly, assets that speculative funds previously used to buy into the yen carry trade, like Hong Kong equities, are now on a volatile downward path, he says.

Seiji Shiraishi, chief economist at HSBC in Tokyo, concurs with the positive outlook for the yen, and the gloomy future of the carry trade.

"One important factor is the interest rate differentials between the U.S. and Japan. While the Bank of Japan will keep the current interest rate of overnight lending

where it is, the Fed may cut several times from now on," explains Shiraishi. "So there should be more unwinding between the yen carry trade position."

Shiraishi sees the yen staying around 110 vs. the dollar over the next month, and rising to 105 against the dollar by next spring.

He says that most Japanese retail speculators have unwound their positions, and describes reports of the phenomenon of the so-called "Japanese housewives" selling the currency earlier in the year as "exaggerated."

If that is the case, then U.S. yen-denominated ETFs like the

CurrencyShares Japanese Yen Trust

(FXY) - Get Report

may be one of the strongest performing investments in Asia in 2008.

However, not everyone is convinced of the yen's upward fate. Adrian Foster, head of capital markets for Dresdner Kleinwort in Beijing, has been skeptical of an overvalued yen since the beginning of the year.

In March, he published a research note to the bank's clients advising that "Japan Inc. won't let the JPY strengthen too fast for fear of denting the economy or wiping out too much of accumulated carry gains. You need to generate a pretty serious shock to change this calculation, I think."

Now, says Foster, that shock has come in the form of subprime, but "the point about denting the economy stands."

In other words, the Bank of Japan will not let the yen rise too fast, for too long, because as an export economy, it is at the expense of its own growth.

There is already some support for this theory. Last week, Japan's Prime Minister Yasuo Fukuda stated that the yen was rising "too fast," and that speculators should "be cautious" about political intervention if they continued to bid up the currency.

"At different times the myriad other investors enter the market and push

dollar-yen around. It can be the mums and dads of Japan or the hedge funds of the world. In both instances, a herd mentality can develop that is self-sustaining for a period," he explains.

"The question now is at what level do the original structural players return to stabilize the JPY? My guess is, we're pretty close to those levels now," adds Foster.

In what is a deeply divided situation, strategists such as Tim Rocks from Macquarie Bank in Hong Kong, support Foster's view.

"There is a natural thing in normal market conditions for the yen to weaken. My bias would still be that the yen carry trade will probably come back at some point -- probably within the next six months," says Rocks.

Dealers say the best way to take advantage of an uncertain yen, and uncertain prices in Asian and emerging market shares, is to buy the companies and the yen ETFs at the same time. In this way, as the carry trade unwinds, the yen ETFs rise, while the shares may decline on decreasing liquidity, and vice versa.

Among the recent volatility in telecoms like

China Mobile

(CHL) - Get Report

and commodity stocks like

PetroChina

(PTR) - Get Report

, this strategy is gaining increasing appeal among Asian investors.

Most consumers and investors alike feel the pain of the yen's gain, in higher prices for products like electronics and cars. Japanese exporters, like

Sony

(SNE) - Get Report

,

Canon

(CAJ) - Get Report

and

Toyota

(TM) - Get Report

, are forced to raise prices as margins erode when these companies convert their earnings back into yen.

Daniel M. Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at

www.theglobalperspective.biz

. He lives in New York.