The U.S. dollar and the Japanese yen: An interesting partnership

Many find a complicated proposition in trading the Japanese yen against the U.S. dollar (USD/JPY). However, when the Japanese yen is understood in terms of U.S. Treasury bonds, notes and bills, it should become less complex.

The main driver of this currency pair is not only Treasuries, but interest rates in both Japan and the U.S. This means that the pair is a measure of risk that determines when to buy or sell the USD/JPY, in terms of interest rates. The direction of this pair can be determined by the direction of interest rates. (For further background reading, see "The Credit Crisis and the Carry Trade.")

The USD/JPY currency pair has traditionally had a close correlation with U.S. Treasuries. When Treasury bonds, notes and bills rise, USD/JPY prices weaken. The logic of investing in this currency pair is that the U.S. would never default on its bond obligations, providing a secure, safe haven status and ultimately making this allocation a long position.

Furthermore, when interest rates are heading higher during the course of a trading day or are suspected to move up in the future, Treasury bond prices will go down. This will lift the U.S. dollar and, in turn, USD/JPY prices will strengthen, and thus we can conclude that the market is in search of yields from Treasury trades and a lower USD/JPY price (making this a short position). Yields, defined as the rate of interest paid on a Treasury instrument, have an inverse relationship with bond prices. Therefore, when yields slump, a flight to liquidity occurs and this liquidity must find a home, which is where currencies can become attractive.

The USD/JPY pair can also be a determinant of market risk. For example, when markets are in search of risk trades, Treasury bond yields will rise as interest rates fall. Yields are also a determinant of risk, as its inverse correlation to USD/JPY prices indicate a degree of volatility due to the market's ability to turn quickly when panic occurs. In the case that panic or fear hits the markets, Treasury bond prices will rise, yields will fall, the price of the U.S. dollar will go down and the USD/JPY pair will appreciate. This is due to the yen's status as the premiere funding currency. For example, by selling a lower-yielding currency such as the yen with current interest rates below its major trading partners (i.e., U.K., U.S., Canada, Switzerland, Australia and New Zealand), investors can seek higher interest rate instruments within its major trading partners for carry trade purposes.

Carry trades have been a major funding source for investors. For instance, if you sell the USD/JPY for U.S. dollars and use those dollars to obtain higher yielding instruments such as Treasury bonds, then you're able to boost your returns. (To learn more, see Profiting From Carry Trade Candidates.)

For example, say a trader sells the USD/JPY pair at a 0.5% interest rate in Japan and buys Treasury bonds, earning 3% interest with a 5% yield. This is seen as a positive carry trade due to the lower level of risk being assumed.

Similarly, U.S. stock markets and the USD/JPY also have inverse relationships. When stock markets rise, bond prices fall, yields rise and the USD/JPY is often sold due to the opportunity for higher returns for the risk being assumed.

It's also important to note that because the USD/JPY pair trades in Asia, the same bond, stock and dollar correlations hold as they do in the U.S. Japanese government bonds (JGBs). When JGB prices are down in Asia trading, the USD/JPY is down as well and means bond yields and the Japanese stock market are up.

Short- and long-term investors may want to employ different strategies when it comes to trading the USD/JPY pair. For instance, short-term traders may want to monitor two-year Treasury bonds and the stock market, while long-term traders would benefit from paying attention to the 10- and 30-year bond numbers.

Due to the nature of the USD/JPY pair's correlations to the stock and bond markets, it is worth looking at the S&P indexes for possible early warnings of changes in correlations. (For further reading on currency market indicators, see: Make Your Currency Cross Your Boss.)

These changes in correlations may occur for several reasons. For example, if the U.S. issues more debt by sales of Treasury bonds and adds money to the system, bond prices may dilute and have varying effects on the USD/JPY pair. What if the U.S. buys back Treasury bonds and adds money to the system? Would that mean a positive correlation for the USD/JPY pair? The answer is varied in that it is based on good economic outlooks versus recessionary environments.

When evaluating the relationship between the USD/JPY currency pair, the economic laws of supply and demand will ultimately serve as a strong factor in pricing, but is also closely tied to bond pricing in their respective countries. One way that investors express their views on the pair is through a carry trade, commonly viewed by the market as a negative for Japan's economy because it deflates its currency (this is a USD/JPY short). Yet if Japan repatriated its yen home, this would be USD/JPY positive and a buy indicator, because it weakens its currency and strengthen its economy.

Additionally, nations with trade surpluses will often see the USD/JPY pair as a favorable investment, because the market traditionally views this pair as a chance to seek greater buying power and higher interest.

For further reading on currency trading, check out our Forex Walkthrough.