The spike in volatility was easy enough to understand. Basically, the possibility of a default by a member of the EU or even worse, a breakup of the Euro created massive uncertainty in the markets, spurring the flow of capital from regions and assets perceived as risky to those perceived as safe havens. As you can see from the chart below, this trend has begun to reverse itself, but still remains prone to sudden spikes.

While the crisis in the EU seems to have (temporarily) settled, investors are attuned to the possibility that it could flare up again at any moment. A failed bond issue, a higher-than-forecast budget deficit, political stalemate, labor strikes – all signal a failure to resolve the crisis, and would surely trigger a renewed upswing in volatility and sell-off in risky assets.

The same goes for (unforeseen) crises in other regions, affecting other currencies. Muses one analyst: “Next week? Who knows. One strong candidate is for flight out of the yen as investors start to fear there won’t be enough domestic demand for mountains of Japanese debt and foreign buyers will insist on much higher yields. Another might be that Swiss banking exposure to insolvent east European households causes another banking crisis.” Don’t forget about the UK and US, both of which have hardly put the recession behind them, and whose Trillions in debt represent powder kegs waiting to explode.

It will be months or years before these latent crises even begin to manifest themselves, let alone achieve some kind of resolution. As a result, many analysts predict that volatility will remain high for the foreseeable future: “Big and sudden currency market moves shouldn’t come as a surprise, whatever the direction…Higher market volatility should follow on from greater macroeconomic volatility. Increased economic fluctuations increase uncertainty. And there’s no question macroeconomic volatility has risen.”

In addition, there is no way for governments for Central Banks to alleviate these crises due to the “Trillema of International Finance.” Greg Mankiw, Harvard Economics Professors, explains that in prioritizing an independent monetary policy and open capital markets have forced many countries to forgo exchange rate stability: “Any American can easily invest abroad…and foreigners are free to buy stocks and bonds on domestic exchanges. Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.” While the Euro has eliminated exchange rate fluctuations between members of the Eurozone, meanwhile, there is nothing that the ECB can (or desires to) do to minimize volatility between the Euro and outside currencies.

From the standpoint of forex strategy, there are a couple of lessons that can be learned. First of all, the carry trade will remain underground until volatility returns to more attractive levels. Until then, the potential gains from earning a positive yield spread will be offset by the possibility of sudden, irascible currency depreciation. Second, growth currencies – despite boasting strong fundamentals – will remain vulnerable to sudden declines. That doesn’t mean that they should be avoided; rather, you should simply be aware that small corrections could easily turn into multi-month weakness.

The rally is being driven by two principal factors. First, investors came to the gradual realization that the trend towards risk aversion had reached extreme proportions. Given that the crisis in the EU has been fairly limited both in scope and extent (at least so far), it made little sense to punish emerging markets. If anything, emerging markets should have been the financial safe havens: “Debt-to-GDP ratios in the developed world are about double those in emerging markets, and they’re growing. This makes emerging markets interesting because you’re picking up incremental spread and in return you’re actually taking less macroeconomic risk.”

Other analysts see a certain futility in targeting a risk-averse strategy: “It’s not that people suddenly think emerging markets are a lot safer, it’s that they’re realising risk is everywhere and they can’t just assume the developed world is safe.” In other words, some investors are wondering whether it doesn’t make sense to focus less on risk – which  has become increasingly random – and more on return. In this aspect, emerging market investments of all kinds are more attractive than their counterparts in the developed world.

The second source of momentum for the rally is a long-term shift in capital allocation. Thanks to foreign demand, Emerging Market “borrowers, including governments and companies, have raised almost $300bn (£200bn) to date, up 10 per cent on the same period in 2009.” A microcosm of this surge can be seen in US mutual funds: “Emerging market equity funds…posted combined inflows of more than $3 billion for the week ended July 14, while emerging market bond funds took in $745 million, bringing their year-to-date inflows to an all-time high of $18.5 billion.”

Across all sectors, money is pouring into emerging markets at an even faster pace than before the credit crisis. This time around, however, analysts argue that it is justified by fundamentals: “Economies in the developing world are slated to grow 6.3% this year and are expected to maintain a similar growth rate through 2013, according to the International Monetary Fund. Advanced economies are seen expanding around 2.4% annually over the same time period.” The Brazilian economy alone expanded at an annualized rate of 9% in 2010 Q1, the fastest rate in 15 years!

Emerging market investors share the confidence of foreign investors, and it seems the flow of funds will primarily be one-way. According to a recent survey, “Just 19 per cent of Brazilians, 15 per cent of Indians and 11 per cent of Chinese…said they anticipated increasing cross-border investment.”

At this point, the only thing that could derail emerging markets is if investors get too ahead of themselves. According to Citigroup, “Developing-nation shares will rally 20 percent to 25 percent by the end of this year as the world economy avoids a double-dip recession and attractive valuations lure investors.” That would bring share prices past the current level and dangerously close to the pre-credit crisis highs of 2008. The JP Morgan Emerging Market Bond Index (EMBI+) has already shattered its previous record, and given the current spread of only 300 basis points to US Treasuries (which themselves are trading near all-time lows), one has to wonder if investors aren’t at risk of re-entering bubble territory.

If for whatever reason investors get spooked, it could spark the same capital flight that followed the bankruptcy of Lehman Brothers, in which emerging market and commodity currencies alike fell 30-50% over a duration of mere months. While no one is predicting a similar outcome this time around, I think prudence and caution are nonetheless advisable.

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.