J.R. Crooks: Remember the Japanese yen carry trade? That was when investors would borrow yen to fund investments in higher-yielding risk assets. It served to suppress the value of the yen for a long time until the trade unwound.

It came unwound for sure … and never wound back up. In fact, almost the opposite is true.

The Japanese yen (NYSEARCA:FXY) has, almost under the radar, crept higher over time — defying what appear to be burdensome domestic fundamentals amid a downshifting global economy.

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August 13, 2012: Japan’s economy grows by 0.3% in the second quarter, half of what was expected.

Japan (NYSEARCA:EWJ) is still the world’s third-largest economy, and here are some of the factors keeping it afloat.

• The sheer size of its industrial base and explicit export model has helped it maintain a current account surplus.
• Because Japanese debt is largely domestically funded, its market is extremely liquid.
• Bonds have represented a safe haven for both retail and institutional investors.

Together, these factors have allowed Japanese policymakers to steadily manage the budget gap.

Japan’s lost decade(s), of which we’re oft reminded, have created a constant repatriation flow from domestic investors. This supports the yen and effectively makes it a safe-haven play.

But the capital flows based on that safe-haven appeal could quickly be its undoing.

Japan has a substantial industrial base, and its economy is heavily dependent upon growth in its export market. But there are obvious problems with the sustainability of such a growth model:

1. The questionable health of the global economy, and external demand, weighs on Japan’s exports.

2. The appreciation of Japan’s currency, based on safe-haven inflows, slowly but surely makes its exports less competitive vs. exports from emerging industrial economies in Asia.

These headwinds factor into the overall health of Japan’s economy.

A lack of external demand leads to inventory buildups, which lead to a production drop. A drop in production hits revenues and, eventually, employment. Rising unemployment undermines the consumer sector, savings and the appetite for borrowing.

Thus, investor perception regarding Japan as a safe haven could shift dramatically.

Though it’s not likely to happen overnight, make no mistake — risks are building. The growth model based on exports is in trouble. Global growth is waning. And Japan’s ability to fund debt internally is fading.

If investors begin to react to this risk, it would likely feed directly into Japanese bonds.

It would push yields, making it even harder for Japan to fund its widening deficit, as you can see in the chart below:

The Japanese government looks to fund this widening gap with substantial amounts of debt:

Japan’s Ministry of Finance, and others, estimate that 90% of Japanese debt is financed by Japanese households who have historically maintained a high rate of savings. But the demographics are decidedly negative for this dynamic going forward, and the household savings rate is fast-approaching zero.

But there has been another element that’s allowed the Japanese to maintain this status quo of debt management throughout a lengthy period of subdued economic growth …

Low Interest Rates Make the World Go ‘Round

We hear every day of every week about the Federal Reserve’s interest rate policy — i.e., an extended period of low interest rates.

Investors very much believe the Fed is backed into a corner and must keep interest rates low to make affordable the servicing of current debt obligations and the financing of new government expenditures.

By the same token, low interest rates in Japan have kept the cost of debt manageable — further perpetuating the status quo.

Should the pressure on exports become greater, and cause even more of an economic slowdown, Japan’s perceived safety could be undermined quickly.

Most likely, Japan will run into the potential of sovereign-debt downgrades, as falling household savings and worsening demographics sap demand for Japanese bonds.

This means the Japanese government could desperately start seeking new buyers for its bonds, and soon.

Japan: Desperately Seeking Bond-Buyers?

The government could look outside of Japan. But the odds of foreign investors lending the Japanese government money at exceptionally low interest rates while Japan’s economy suffers are not good.

Thus, a hike in interest rates to attract these international buyers would threaten the government’s ability to fund its debts and raise the specter of sovereign-debt default. Therefore, rising interest rates could lead to a self-feeding vicious circle indeed.

When might such developments materialize?

Though the numbers suggests things are playing out as I expect, the market timing is a different story.

The Waiting Game

There is good reason to believe the real pressure will come after the worst of the euro-zone debt crisis passes. With that finally out of the way, speculators might then turn their big guns on Japan.

That said, I am not optimistic the euro crisis will end anytime soon. At the least, the current debates and bailout schemes will likely last another few months, at the least.

And even once those chips fall where they may, the ultimate problems will likely not have been solved.

Whether the euro-zone system or its single-currency arrangement dissolves seems mostly up to Germany, along with whether it wishes to concede on fiscal-union proposals.

It might only be after Germany finally decides on the fate of the system that markets and investors firmly turn their attention to the wilting fundamentals in Japan.

Otherwise, inflation expectations may be the deciding factor.

One Way to Leverage a Move in the Yen

One way to play Japan is through the Japanese yen, more specifically the ProShares UltraShort Japanese Yen Fund (NYSEARCA:YCS), which moves higher twice as fast as the value of the Japanese yen falls (relative to the U.S. dollar).

It may make sense to jump on this idea sooner than other Japanese-specific investments. That’s because there is a growing chance the Bank of Japan (BOJ) could intervene with even-more monetary easing measures.

By buying U.S. dollars and selling Japanese yen, the BOJ could perhaps put a ceiling on, and lead investors to sell, the yen. The BOJ has intervened at times in the past. And, for the most part, the market reaction has been relatively short-lived.

But that’s not to say the BOJ’s efforts, should it step in, will be ineffective again. The conditions may, after all, appear more dire to investors overall and technically the charts suggest we are near a long-term peak in the yen.

Additionally, if the BOJ works as hard as, say, the Swiss National Bank to suppress the value of its own currency, it might eventually shift inflation expectations.

The chances seem slim now because of the long-term deflationary trap that has consumed the Japanese economy. But, inflation would be a big surprise and would throw a dangerous element into the management of interest rates for Japan’s ability to service its debt.

That’s something the government hasn’t faced in over 20 years. But, never say never!

Best,

Written By JR Crooks From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss  along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and  Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff  do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance  returns cited are derived from our best estimates but must be considered  hypothetical in as much as we do not track the actual prices investors  pay or receive. Regular contributors and staff include Andrea Baumwald,  John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen  Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker,  Leslie Underwood and Michelle Zausnig.

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