With the Nikkei recently hitting five-year highs, the yen weak and Japan's economy showing signs of picking up, it's been a great time to buy Japanese stocks. The questions now, though, are just how much further the yen will deteriorate and for how long. The weaker yen is good for Japanese exports but it also heightens inflationary pressures, especially considering that Japan needs to import 80% of its energy needs. As oil is again flirting with $60 a barrel, the Nikkei 225 stock average fell 0.8% to 15,423.38 overnight. However, the Nikkei is still within a hair of 15,500, its best level in five years and one that it briefly surpassed on Monday. On Tuesday, the yen dropped to 121.04 against the dollar, a trend that's accelerated since the meeting of the Group of Seven industrialized nations revealed no global concern about the weaker Japanese currency. The dollar, meanwhile, was little changed against the euro, which traded at $1.1785 from $1.1787 the prior day. The greenback remains supported by recent strong economic data and expectations that the Federal Reserve will continue hiking rates. But news that U.S. productivity had improved while labor costs dropped in the third quarter somewhat tempered the views of an aggressive Fed. Equity markets made the most of the data. The Dow Jones Industrial Average was recently up 77.24 points, or 0.71%, to 10,912.25, and the S&P 500 was gaining 9.59 points, or 0.76%, at 1271.68. The The Nasdaq Composite was adding 18.01 points, or 0.80%, to 2275.65. Among the winning stocks, Apple ( AAPL) was rising 3.9% after UBS raised its fiscal 2006 earnings estimate for the company and lifted its price target on the stock to $86 from $74. Google ( GOOG) was gaining 1% after Pacific Crest Securities raised its price target to $500 from $400.
The yen's decline -- it's lost roughly 15% against the dollar this year -- has taken place amid signals that Japan's economy is starting to strengthen after years of underperformance. While an improving economy should normally boost the yen, the Bank of Japan has indicated that it will take its time moving away from its zero interest rate policy. The combination of a weaker yen and a sturdier economy has been prompting increased investments in Japanese equities this year. That's especially true for U.S. investors, who've watched the dollar rise against most currencies thanks to the outlook for continued rate hikes by the Fed. (Three of RealMoney's contributors own the ( JOF) Japan Smaller Capitalization Fund .) For Jack Ablin, chief investment officer at Harris Bank, "from a dollar perspective, now is the time to make your international investments, including in Japan." The opportunity should last through the first quarter, because the Fed is widely expected to boost rates at least two more times, including by a quarter-point next week and another 25 basis points in January. "Clearly, the Fed is the dollar's protector right now," Ablin says. In the short term, the yen has the potential to continue softening against the dollar. The Bank of Japan has begun to fret about inflationary pressures in recent months, but Japanese Finance Minister Sadakazu Tanigaki told the G7 meeting's attendees over the weekend that he remains "comfortable" with the yen at 120 to the dollar. Still, "they haven't given a green light
to an endless weakening ," says David Powell, currency strategist at IDEAglobal. "By 125, people will start screaming intervention again." Powell believes the 125 yen level could be reached over the next several weeks. Even though the Japanese government probably wouldn't intervene, lawmakers likely would step up the rhetoric and hold speculators in check, preventing further depreciation, he says.
Next week's meeting of the Federal Open Market Committee also will be key, given rising expectations that the Fed will finish its rate-hike campaign next year. Hints in that direction may show up in the Fed statement that will be released after the meeting. In a speech on Monday, however, Fed Governor Mark Olson gave no such indication. The Fed, he said, isn't concerned about lifting interest rates too high and hurting the economy. "The economy doesn't typically move so rapidly that it would get away from us," Olson said, according to Bloomberg. As for next year, a number of economists and currency strategists expect that the outlook for the dollar will worsen, while the yen's may improve. In addition to the Fed's actions, the dollar has been heavily supported by U.S. firms repatriating dollars to enjoy tax breaks under the Homeland Investment Act, part of the American Jobs Creation Act, which will expire at the end of the year. According to Ashraf Laidi, currency strategist at MG Financial, the repatriations are estimated at between $200 billion and $500 billion, with about 30% requiring currency conversions into dollars. The yen should have room to appreciate if and when China advances toward revaluing the yuan. The G7 official statement did call on China to move faster on making the currency more responsive to global markets. The People's Bank of China on Monday indicated some willingness toward more currency reform, according to Laidi. He believes China may take another step to revalue the renminbi, by between 1.8% and 2.1%, in as early as three to four weeks.