What Forex Traders Need to Know About the Yen

The foreign exchange market is vast, complicated and ruthlessly competitive. Major banks, trading houses, and funds dominate the market and quickly incorporate new information into the prices.

Therefore, forex trading is not a market for the unprepared. To effectively trade forex on a fundamental basis, traders must be knowledgeable when it comes to the major foreign currencies. This knowledge should include not only the current economic stats for a country but also the underpinnings of the respective economies and the special factors that can influence the currencies, such as commodity movement or interest rate changes.

Introduction to the Yen

Just seven currencies account for 83% of the forex market, and the Japanese yen is one of the largest currencies, in terms of international trade and forex trading. Japan is one of the largest economies in the world, with one of the highest GDP among nations; it is also one of the largest exporters, in dollar terms.

All of the major currencies in the forex market have central banks behind them. In the case of the Japanese yen, it is the Bank of Japan (BoJ). Like most developed-country central banks, the Bank of Japan has a mandate to act in a fashion that encourages growth and minimizes inflation.

In the case of Japan, however, deflation has been a persistent threat for many years, and the BOJ has pursued a policy of very low rates in the hopes of stimulating demand and economic growth; at various points in the 2010s, real rates in Japan were actually slightly negative.

The Economy Behind the Yen

The Japanese economy has some particular and peculiar attributes that yen traders need to understand. Firstly, despite its size, Japan has been notably lacking in growth since the collapse of its equity and real estate bubbles in 1990. Writers often refer to the ensuing years as a "lost decade" in Japan because of this reason. Since then, growth rarely exceeded 2% in Japan between 2001 and 2011, and went down 29% from 2012 to 2015. Japan is also notable for inflation, or rather its almost near-absence of it; Japan has actually experienced deflation for much of the last 20 years.

Second, Japan is also among the oldest major economies in the world and has one of the lowest fertility rates. That suggests an increasingly aging workforce with fewer and fewer younger workers to support the economy through taxation and consumption. Because of this Japan, once quite closed to immigration, recently began opening its borders to foreign workers to address labor shortages.

Lastly, Japan is also an advanced economy with a well-educated workforce. Although industries like shipbuilding have somewhat migrated to countries like South Korea and China, Japan is still a leading manufacturer of consumer electronics, autos, and technological components. This has left Japan with significant exposure to the global economy.

Drivers of the Yen

There are several theories that attempt to explain foreign exchange rates. Purchasing power parity, interest rate parity, the Fisher effect and balance of payments models all offer explanations of the "right" exchange rate, based on factors like relative interest rates, price levels and so forth. In practice, these models do not work especially well in the real market—real market exchange rates are determined by supply and demand, which includes a variety of market psychology factors.

Major economic data includes the release of GDP, retail sales, industrial production, inflation, and trade balances. Investors should also take note of the information on employment, interest rates (including scheduled meetings of the central bank) and the daily news flow; natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

In the case of Japan and yen traders, the Tankan survey is particularly noteworthy. Many countries report information on business confidence, and the Tankan is a quarterly report published by the Bank of Japan. The Tankan is seen as a very important report, and often moves trading in Japanese stock and currency.

In many respects, BoJ policy drives carry trades across the world. Carry trading refers to borrowing money in a low-interest-rate environment and then investing that money in higher-yielding assets from other countries. With a stated policy of near-zero interest rates, Japan has long been a major source of capital for that trade. That also means, though, that talk of higher rates in Japan can send ripples throughout the currency markets.

Unique Factors for the Japanese Yen

While the BoJ has maintained low rates since Japan's property bubble collapsed, the bank has also been involved in currency intervention—selling the yen to help keep Japanese exports more competitive. This intervention has carried political consequences in the past, however, so the bank is relatively hesitant to intervene in the forex markets.

Japan's trade balance also impacts BoJ policy and forex rates. Japan has historically had large trade surpluses, but very large public debt and an aging population. A large percentage of that debt is held domestically, though, and Japanese investors seem willing to accept low rates of returns.

While Japan has very high debt levels, traders tend to be more comfortable with Japan's debt balance. Moreover, traders often balance the high debt level of Japan with its usual high trade surplus, though the devaluation of the dollar and the "safe haven" status of the yen have led the Japanese coin to become so strong that it threatens the very trade surpluses that makes it attractive. Indeed in the last decade they have uncharacteristically run an increasing amount of deficits.