How undervalued is the yen?

I just read an excellent article in the most recent Economist discussing the undervaluation of the Japanese yen, which their editors assert is putting the global economy at serious risk. This story ties in closely with an earlier article about the carry trade, of which the yen forms an integral part because of low Japanese interest rates.

The Economist's take on the situation is that speculation by carry traders combined with complacency by world governments is holding the yen's value down at an artificially low level. How low? The article claims it could be undervalued by as much as 40% vs the Euro. That's a lot. And when the yen finally does begin to adjust upward (not if, but when), there are as many as $1 trillion in carry trade positions that will start unraveling with every pip it rises.

Say you've bought the GBP/JPY pair with a highly leveraged forex account and are making a nice profit off the dramatic interest differentials between these two pairs. Suddenly the yen appreciates by 1%. Then 2%. Then 5%. It's not a pretty picture. There's a reason this strategy has been called "Picking up nickels in front of a steamroller." So if you've been pursuing a carry trade system with the yen, this article is a compelling argument against complacency in your positions.

One of the most informative parts of the article for me was its discussion of how hundreds of billions of dollars in yen carry trades aren't closely tracked by official statistics. The reason for this is that unlike spot currency traders who will sell the yen to buy a higher yielding currency, hedge funds will instead use financial instruments called currency forward swaps to place their carry trades. How can you measure how much these off-balance-sheet transactions add up to? According to the article, "A better clue comes from record net 'short' positions in yen futures on the Chicago Mercantile Exchange. Estimates of the total size of the carry trade range as high as $1 trillion."

In short, it's well worth reading, whether you're a carry trader or just trade the yen on a regular basis. And even if you don't go near the yen in your trading, keep in mind that any major movement in this currency will have significant spill-over effects into others.

Here's the article: Carry on living dangerously