A weak yen means a fresh potential bonanza for equities

The Japanese yen (JPY) has fallen by 3.5 percent against the US dollar (USD) in the calendar year to date to levels of JPY 79.50. The fall in the yen from highs (the yen was trading at over 12-year highs in the second half of 2011) is an ominous sign for equities.

Equities have rallied anywhere between 10 percent and 20 percent across the globe in the calendar year to date. The Japanese equity index, the Nikkei, has rallied by 12 percent since the beginning of January 2012, as a weaker yen helps Japanese exports.

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A falling yen can be interpreted in two ways: a) Flight to safety trades are going out of the market and, b) The yen is starting to be used as a funding currency. The yen exhibited strength the whole of 2011 as the markets worried about the collapse of the euro and about the debt issues in the US.

The sovereign debt crisis in the eurozone reached a boiling point in 2011 with talks of many countries going out of the euro leading to a collapse of the common currency. US debt issues, with the country having had to raise the debt ceiling in August 2011 and its rating downgrade by S&P, drove currency bears to the yen. The yen gained over 7 percent against the dollar in the April- December 2011 period even as the euro lost over 10 percent in the same period.

The yen has gained around 50 percent from lows of JPY 140 to the dollar seen in 2007, when markets were at their speculative best.

The Japanese economy contracted by 2.3 percent on an annualised basis in the fourth quarter of 2012. A strong yen, production losses due to flood damage in Thailand and a decline in exports, hurt the economy. Japan had its first annual trade deficit in 2011 on the back of the tsunami that crippled its nuclear power plants in early 2011. Manufacturers in Japan shifted production elsewhere post the tsunami, leading to fall in exports.

The Bank of Japan (BOJ) added $130 billion to its bond purchase programme post the GDP data and set an inflation target of 1 percent, to take the economy out of deflation. Japanese interest rates are set between 0 percent to 0.1 percent and its 10-year bond yield is the lowest in the world at below 1 percent as compared to 10-year yields in the US and Europe, which are at around 2 percent levels.

The quantative easing by the BOJ coupled with low interest rates can lead to the yen weakening further against the US dollar.

A weak yen is seen as a bullish sign for equities and other risk assets. The yen is a classical carry trade currency, given high liquidity and low interest rates. The other yen factor is Japanese savers moving out of low yielding yen deposits into higher interest-bearing currencies. Given that interest rates in the US and eurozone are at all-time lows of 0-0.25 percent and 1 percent respectively, the higher rates are available only in emerging market currencies.

Interest rates in countries such as Indonesia and India are at least five percent more than interest rates in the developed world. The relatively high rates on bonds of indebted eurozone countries such as Italy and Spain, where two-year bonds are trading at around 2.9 percent levels, also offer good carry over the yen deposit rate.

Money moving out of low-yielding yen assets into high-yielding risk assets will drive up the prices of risk assets. Equities and emerging market bonds and currencies will gain on the yen carry trade. India will be one of the beneficiaries of a weak yen, leading to more equity flows into the country. India has already seen $4 billion of FII flows into equity and this inflow will increase as yen liquidity floods the market.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.