In the second half of 1999, the yen came back with a vengeance following a protracted two-year period of unusual weakness. Through most of 2000 markets have essentially been trying to figure out how sustainable this recovery is in light of a fragile and stagnant overall economy. Official attempts (incl. by the G7 and by Japanese authorities themselves) to talk the yen down generally failed.

Before, the key factor in dollar-yen had been a sustained accumulation of excess liquidity in Japan ever since 1996, which had spilled over into large capital outflows not only in the direction of the United States but also in the direction of emerging markets (contributing, inter alia, to crisis-prone, macro-economic balance sheet mismatches in Southeast Asia), with the bottom-line result of sustained yen weakness. This excess liquidity accumulation reflected shrinking credit requirements of a weak economy, heavy injections of liquidity by the Bank of Japan (as measured by the domestic component of monetary base creation) and a growing liquidity preference on the part of Japan's financial sector to strengthen unhealthy balance sheet structures.

The yen then managed to stage an impressive come-back mainly because of early signs of an economic recovery in Japan, in the course of which credit requirements of the economy were likely to grow and liquidity preference was likely to recede. (Yen-dollar has also been biased upwards by yen-euro crosstrades, see our Crossrates page.) Yet, by Spring 2001, two increasingly dominant counter-influences have reasserted themselves: 1. The economic recovery remains too weak and insignificant to really make a difference compared to recent years' environment of no domestic credit growth, heavy capital outflows and a sliding yen. 2. Japanese monetary policy has exhausted its domestic instruments, with exchange rate depreciation the only one left. (The U.S. Treasury always tries to give the impression of urging "domestic demand led growth" in Japan on trade grounds and in order to tranquillize Congress at home, when, in fact, it really favors a weak yen to stimulate international capital inflows into U.S. financial markets and to cheapen electronic components imports for U.S. industry.)

The question, what the Bank of Japan might still be able to achieve with interest rates at close to zero, is hotly debated. (The Bank of Japan chose to raise its target for the overnight rate from zero to 0.25 % in August 2000, but brought it back down to 0.15 % in March 2001 and effectively to zero shortly thereafter.) One thing they clearly cannot influence let alone control are financial investment risks in the United States, i.e. on the other side of the foreign exchange market equation.

While the real side of the U.S. economy has now turned down quite sharply and benchmark interest rates are at a cyclical low, risk premiums in U.S. financial markets are nevertheless at record highs. These risk premiums (for instance, BBB corporate bond spreads over Treasuries) reflect record-high levels of corporate bond debt, much of which had been used to support companies' stock market values by means of debt-financed stock-buyback programs, funded to no small extent at minimum interest rates in Japan. These funds continued to flow from Japan as long as long positions in U.S. corporate bonds could be effectively hedged by selling Treasuries short, in other words as long as spreads could be expected to remain reasonably constant. Now, however, with shrinking Treasuries supply due to a growing budget surplus and with corporate debt measures approaching critical levels, U.S. bond spreads are no longer stable. Any further increase in spreads (for instance, in an environment of falling benchmark yields) is not attracting additional capital inflows but causing losses on hedging positions and requiring exposures to be cut or not to be rolled over upon expiration. Since many of these positions had been directly or indirectly funded by borrowing in Japan (carry-trade), their non-renewal is equivalent to a net decline in Japanese capital exports and, hence, puts upward pressure on the yen against the dollar.

On the other hand, the faster the current cyclical debt reduction process among U.S. corporates unfolds, the better the chances for corporate bond yields to be able to follow benchmark interest rates lower. In this case, corporate bonds can be hedged again with Treasuries and would regain their status as an attractive investment outlet for Japanese excess funds, particularly if credit demand in Japan and the Tokyo stock market themselves fail to stabilize. Capital outflows from Japan into the dollar could then resume to the extent that credit risks in the U.S. cool off, making achievable yields in the U.S. more attractive again on a risk-adjusted basis, with the net result of a weakening yen.

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