Behind the Yen's Surprising Strength

It was counterintuition writ large. Japan sustains a 9.0 earthquake that destroys whole swaths of the densely populated Pacific nation and creates a nuclear crisis that sends people and companies hundreds of miles away fleeing. In response, the Japanese yen soars to its highest level against major global currencies since World War II.

The surge of the yen was one of several signs that investors have confidence in Japan, despite earthquake damage estimated at 25 trillion yen ($309 billion). As of Mar. 23, the Nikkei 225 stock index had climbed 10 percent from its Mar. 15 low. Government bond yields have remained stable at just above 1 percent, meaning Japan can borrow money at low cost. And Japan's five-year credit default swaps—insurance that bond traders buy against the risk of default—are trading at just over 100 basis points, meaning it costs $10,160 a year to insure $1 million of Japanese government debt for five years. That's a relative bargain. Insuring the same amount of Ireland's debt costs $61,600 a year.

One factor behind the strength of the currency was speculation that multinationals, insurers, and investors facing rebuilding expenses would sell foreign assets and convert the proceeds into yen to spend at home. There was a technical factor as well. Many hedge funds borrow money in Japan, where interest rates are low, and invest the money in countries where rates are higher—a strategy known as the yen carry trade. After the earthquake increased uncertainty in the markets, many of them decided to unwind their trades. That meant selling foreign currencies and buying yen. "A lot of people use yen as a funding currency," says Kathy Lien, director of currency research for Global Forex Trading in New York. "It costs next to nothing. But when you have to suddenly sell those high-risk investments, you need to buy yen to cover."

The surging yen posed a problem for Japan. By making exports more expensive, it threatened to cut corporate profits, harming the economy. To prevent that from happening, the G7 nations intervened in the currency markets to weaken the yen. Their efforts had an impact. During trading on Mar. 16 the yen reached a high of 76.46 against the U.S. dollar. By comparison, it has averaged 138 per dollar for the past thirty years. The Group of Seven's intervention brought the yen back down to 81 to the dollar as of Mar. 22.

The effect of the disaster on Japan's economic growth remains a question mark. Economists surveyed by Bloomberg say Japan is likely to see a rebound in the second half of the year. They are split on whether the disaster will push Japan into a recession in the next few months. "The hits to the electricity supply and extent of the hits to the supply chain are making it harder to analyze," says Michael Buchanan, chief Asia-Pacific economist at Goldman Sachs (GS) in Hong Kong. The longer it takes to restore electricity, he says, the greater the damage will be.

The bottom line: The yen soaring to a high against the dollar was one of several signs that global investors have faith in Japan's ability to pay for rebuilding.

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