"There were two big drivers of yen strength at the end of last year. First, there was the unwind of carry trades. Then, because carry trade unwinds were closely correlated to what was happening in terms of risk capita, to be short dollar/yen or short euro/yen was an easy proxy hedge for equity investors," commented James Malcolm, emerging markets foreign exchange strategist at Deutsche Bank in London.
Research from Barclays reveals the yen has become less well correlated with equities as a result of the majority of carry positions being unwound. "As a result of yen-funded carry positions having gone, the correlations between equities and the yen crosses have been breaking down since the start of the year. The sensitivity of dollar/yen to MSCI World is about 20% of what it was a year ago," said David Woo, head of foreign exchange strategy at Barclays in London.
Woo also cites a delayed impact of the sell-off in the US Treasury market - which has gained momentum since the start of the year - as being instrumental in the fall in value of the yen.
"The interest rate differential has actually been moving against the yen in favour of the dollar since the start of the year," explained Woo. "This move up in dollar/yen, in some sense, could be seen as a catch-up with the big sell-off in US Treasuries since the start of the year."
Woo also affirmed the amount of power-reverse dual currency notes (PRDCs) outstanding in the market has been reduced signifcantly. PRDCs are products used by investors to express the view that the yen will strengthen as much as the forward curve implies. If the yen increases to a certain value, coupon payments would drop to 0%.
However, other analysts have played down the significance of carry trades in the fall in value of the yen, rather pointing to other economic factors. "I would say the carry trade has not been an issue for some time now," said London-based Hans Redeker, global head of forex strategy at BNP Paribas.
According to Redeker, Japanese real-money account managers have been increasing their exposure to foreign equity markets and reducing their exposure to bond markets. This means less currency-hedging activity, as equity exposure tends not to be currency-hedged.
The sharp drop in world trade causing Japan's current account surplus to implode - falling from $27.9 billion in March 2007 to $1.3 billion by December 2008 - has weakened the currency further. "We have four months in a row of negative trade balance in Japan. Bearing that in mind, the commercial yen buying need is very different from the commercial yen buying need a year ago," observed Redeker.
Also, the Japanese government may act to support equity prices, fearing the cross-holdings of Japanese corporates and banks could have a negative impact on their balance sheets. To this end, the finance ministry has announced a ¥20 trillion stimulus plan and quantitative easing has been suggested by the Bank of Japan.
Regardless of the reasons provoking the fall in value of the yen, analysts agree that interest rate differentials allow little scope for carry trades at the moment. "We think it is very unlikely carry trades will make a comeback within the next year," Woo said.