As to what’s propelling the Yen higher, there is very little mystery. Two words: Safe Haven. “The yen’s attractions lie in its status as a haven from the turmoil that has engulfed financial markets as, first, the eurozone debt crisis unfolded and, then, fears about a double-dip recession have intensified.” To be sure, there are a handful of currencies that are arguably more secure and less risky than the Yen. The problem is that with the exception of the Dollar, none of them can compete with the Yen on the basis of liquidity. In addition, thanks to non-existent inflation in Japan and low interest rates in other countries, there is very little opportunity cost in simply holding Yen and simply taking a wait-and-see approach.

According to some analysts, interest rate differentials will probably remain narrow for the foreseeable future: “Global bond yields will fall, reducing the incentive of yen-based investors to place funds abroad.” In fact, thanks to low interest rate differentials, the Yen is not even the target funding currency for carry traders. Suffice it to say that investors are not bothered by the fact that Japanese monetary policy is extraordinarily accommodative and that Japanese long-term interest rates are the lowest in the world. For those who are concerned about rising interest rate differentials, consider that this probably won’t become a factor until the medium-term.

On the fundamental front, there are a couple of risks for the Yen. First of all, there is the stalled Japanese economic recovery and the possibility that the strong Yen could further erode the competitiveness of Japan’s export sector, the mainstay of its economy. Yen bulls respond to this by noting both that Japan’s economic recovery has already stalled for 25 years and that should the Yen’s rise actually crimp economic growth, the Central Bank would probably intervene. By all accounts, “The government will continue to keep a close eye on the yen.”

A greater concern, perhaps, is Japan’s massive debt. Near $10 Trillion, public debt is already 180% of GDP, and is projected to grow to 200% over the next few years. Total public and private debt, meanwhile, is by far the highest in the world, at 380% of GDP. The Japanese government is planning to implement “austerity measures,” but political stalemate and election pressures will make this difficult to achieve.  All three of the rating agencies have issued stern warnings, and downgrades could soon follow. Here, Yen bulls retort that as unsustainable as this debt might appear, the majority (90%) of it is financed domestically, through the massive pool of savings. The remaining 10% is eagerly soaked up by foreign investors, who view the debt as a more attractive alternative to cash and stocks. [This is the great irony that I alluded to in the title of this post - that more debt is viewed positively as "liquidity" and does nothing to hurt the Yen].

Speaking of which, the Japanese stock market has risen by only 5% this year, and some analysts are predicting that a long bull market is inevitable. Adding to the fervor, Central Banks have begun to build their positions in the Yen, for the first time in 10 years. It seems everyone is excited about the Yen, even economists: “Within the developed economy space, Japan looks relatively good as an economy that’s likely to be growing faster than Europe or America, and it’s generally considered to have low risk of capital flight.” In other words, the consensus is that there is a very low chance of a “Greek-like debt crisis.”

At this point, the Yen can only be toppled by Central Banks: either foreign Central Banks will hike interest rates and make the Yen unattractive in contrast, or the Bank of Japan will intervene directly to prevent it from rising further.

Lately, this notion has manifested itself in the EUR/USD exchange rate, with the Euro embodying risk, and the Dollar embodying safety. In fact, a carry trading strategy has unfolded along these lines and made this phenomenon self-fulfilling: traders have taken to reflexively selling the Dollar when news is good and selling the Euro when news is bad.

In recent weeks, this approach appears to be changing. It started with the US stock market, which began to decline, even as the Dollar was still rising. Investors had started to worry about the housing market stalling, the exhaustion of the government stimulus effect, and worst of all, the possibility of a double-dip recession. The most recent data “showed U.S. gross domestic product in the first quarter grew more slowly than expected…The U.S. GDP numbers came after some weaker-than-expected housing numbers and a dovish Federal Reserve, all of which drove U.S. Treasury yields lower and prompted investors to reassess their dollar positions.”

From my point of view, it is not the possibility of a prolonged recession that is itself noteworthy (though this is surely cause for concern), but rather that the currency markets are paying attention it. To be sure, news of the EU sovereign debt crisis continues to dominate headlines and influence investor psychology. Barring any unforeseen developments, however, this crisis probably won’t evolve much further in the short-term, and it’s logical that investors should turn their attention back to the data.

As a result, “The popular risk-related trade on the euro ‘that was prevalent in the first half of this year appears to have derailed for the time being as market players increasingly focus on comparative fundamentals once again,” summarized one trader. In fact, the Dollar has fallen by 5% over the last month, both against the Euro and on a trade-weighted basis.

Over the long-term, analysts are divided over which narrative will determine the EUR/USD rate. It would seem that until there is some resolution to the sovereign debt crisis (whether positive or negative), an air of uncertainty will continue to hang over the Euro such that it remains an apt funding currency for a carry trade strategy. US capital markets are the world’s deepest, most liquid, and most stable, and in times of crisis will probably continue to attract risk-averse capital.

On the other side are those who argue that the US will shed its safe-haven status and become a growth currency. According to this line of thinking, the US economy will outperform the EU, Japan, and Britain – its peers/competitors in the Top Tier of currencies.
“The euro zone has been stricken by crisis over the debts of its weaker members. Japan will only emerge slowly from deflation and the U.K. has to deal with its record high budget deficit over the next few years,” argued one analyst.

As a result, “The dollar will return to a pattern seen in the early 1980s and late 1990s, when it appreciated as stocks rose…The likelihood that the dollar performs strongly rather than weakly when investors are risk-seeking will signify a major change in the currency markets.” Under this paradigm, the Japanese Yen and the Swiss Franc would probably become even further entrenched as safe-haven currencies.

Finally, it’s worth pointing out that such a paradigm shift wouldn’t necessarily be good for the Dollar. If the US is indeed able to put the recession behind it, then a renewed focus on growth fundamentals would send the Dollar higher. If the Double-Dip materializes, however, Dollar bulls will probably find themselves hoping that the Dollar can retain its safe haven status.

Analysts attribute the Yen’s resilience to a series of aberrant developments, rather than to some kind of cohesive trend. Above all, there is the sovereign debt crisis in Europe, which has directed a steady stream of risk-averse capital to Japan. Under the existing paradigm, the US, Japan, Switzerland, a handful of other economies are still thought of as financial safe havens, a notion which serves to explain the Yen’s surge to a 10-year high against the Euro.

This is not exclusively a one-way trend. On the contrary, there is a constant ebb and flow in risk-tolerance as investors weigh the seriousness of the EU debt debacle and other crises. In fact, some believe that the recent uptick in risk aversion is already in decline: “Once investors shift their attention back to the fundamentals, which are still signaling solid improvement, there is no strong reason to buy the yen. Underlying demand for higher-yielding assets outside Japan remains strong.”

Outside of this, there is also some debate as to what constitutes a safe-haven currency, and whether the Yen qualifies. On the one hand, Japanese interest rates are extremely low and monetary policy remains accommodative. It’s capital markets are deep (though not exactly buoyant), and for investors that value capital preservation, Japan would seem like a reasonable choice. On the other hand, this mentality is facing a backlash as a result of prolonged political uncertainty. Since unseating the Liberal Democratic Party in 2009 – an historic achievement – the Democratic Party has been in a dither and implemented no new, meaningful policies. The finance minister was replaced a few months ago, and to top it off, the Prime Minister himself is set to resign.

It is both the uncertainty – the perennial enemy of the carry trade – and the potential replacement which worries investors and currency traders. The current front-runner, Finance Minister Naoto Kan, has not made a secret of his desire for a weak Yen: “Markets in principle should determine foreign exchange rates, but I think we must closely watch [markets] and ensure that there won’t be any excessive yen rises.” As Prime Minister, he would probably be more aggressive than his predecessor in intervening in currency markets, if need be.

Perhaps with Mr. Kan’s support, the Central Bank of Japan recently announced that it would inject $20 Billion into capital markets as part of of an effort to “calm” the financial markets. The Central Bank is apparently committed to “combating deflation,” which in some circles is code for currency devaluation.

In short, the only real question – posed in the title of this post – is the exchange rate that the Japanese leadership is targeting. Currency valuation is always more art than science, so it’s unclear not only the rate that in reality is fair, but also the rate that Japan perceives as fair. My feeling is that it’s north of 95 Yen/Dollar. It seems that anything between 90 and 95 is acceptable, while a drop below 90 is cause for intervention. For now, that intervention has been entirely vocal; if the government’s approval ratings remain in the basement, however, it could turn into actual intervention.

On the surface, the Japanese Yen would seem to be an excellent candidate for shorting, especially in the context of the the Greek fiscal crisis. Its fiscal and economic fundamentals are abysmal, and by most measures, it’s debt position is among the least sustainable in the world, behind even Spain, Portugal, and the US. At the same time, the Yen has risen by an unbelievable 8% against the Euro in the last week alone, and many analysts are predicting it will emerge as one of the winners of this episode.

Why? First of all, with confidence in the Euro flagging, the Yen (and the Dollar) gain luster as the only viable reserve currencies. Regardless of what you think about Japan’s fiscal fundamentals, the longevity at the Yen means that it is inherently safer than the Euro, which may not even exist (in its current form, at least) in a few years time. Second, the current consensus is that the Euro bailout will fail, and as a result, risk tolerance is running low at the moment. With this in mind, it’s no surprise that traders are unwinding their carry trades and that the Yen – “The low-yielding currency of a deflation-prone economy of high savers…entrenched as the world’s funding currency” – has rallied.

Analysts have been quick to point out that the rest of Asia (among other regions) are on the other side of this trend. The concern is that the bailout won’t be enough to prevent a repeat credit crunch and that confidence in investments/currencies that are perceived as risky will remain low.

China could be hit especially hard. Since the Chinese Yuan is pegged to the Dollar (and even it wasn’t), it has risen by a whopping 15% against the EUro over the last six months, severely crimping exports to the EU. In addition, “Chinese exporters rely very heavily on bank letters of credit to finance their shipments…When banks have trouble borrowing money themselves — as has been happening as a result of worries about European banks’ possible losses from the region’s sovereign debt crisis — they tend to cut sharply the issuance of letters of credit for trade finance.” It’s no wonder that the Chinese stock market has tanked 21% so far in 2010, and that the Central Bank continues to delay revaluing the RMB.

Of course, if the plan turns out to be a success, than the opposite will probably obtain. “In this case…the currency of any emerging market or advanced economy exposed to the Asian region’s impressive, China-led economic growth,” will probably rally. “It could be the South Korean won, the Australian dollar, or the currencies of commodity-producing countries like Brazil.” The Japanese Yen, meanwhile, will probably be hit with a dose of reality, followed by a double dose of the carry trade.