Yen selling by foreign investors to reduce their exchange rate exposure, after buying a record amount of Japanese securities last year, could further drive the currency down toward 115 to the dollar in coming months.
The yen has already slid 10 percent against the dollar since mid-January to hit 14-month lows around 113.75 this week, and the erosion in the dollar-based value of Japanese assets is forcing investors to hedge against further yen weakness, dealers said.
"The dollar's strength against the yen has been persistent lately, regardless of whether it's rising or falling against the euro. This is because foreign players are constantly buying dollar/yen on dips," a Japanese city bank trader said.
The need for foreign investors to hedge their yen exposure increased after the dollar established a solid foothold above the psychologically crucial 110 yen level this month, convincing them that the yen's three-year rally had peaked in January and further losses were likely. Dimming the yen's outlook were widening US-Japan interest rate differentials and political uncertainty in Japan, where Prime Minister Junichiro Koizumi may call a snap election if his bid to reform the postal system is rejected in parliament.
Expectations of higher US interest rates were bolstered by Federal Reserve Chairman Alan Greenspan's congressional testimony on Wednesday that the US growth outlook was solid and the Fed would keep raising rates.
"People are buying high-yield currencies," said Makoto Kojima, an executive director at UBS AG in Tokyo. "With the yen's interest rates so low, buying the dollar against the yen makes perfect sense as a carry trade."
In a "carry trade," a trader borrows funds in a currency with low interest rates and buys another currency that offers higher deposit rates. This position also gains from a rise in the exchange rate of the higher-yielding currency. The US federal funds rate has been raised nine times in the past year to 3.25 percent from 1.00 percent, and a Reuters poll shows dealers expect it to rise to 4.00 percent by the end of the year.
Japanese political turmoil could fuel independent yen weakness, ahead of a closely watched parliamentary vote next month on postal system reform, a key pillar of Koizumi's reform programme.
The vote marks a showdown for Koizumi and the old guard of his own ruling Liberal Democratic Party, and the party could fall from power if the prime minister calls a snap election.
Foreign investors bought a record net 15 trillion yen ($133 billion) of Japanese securities in 2004, of which about 70 percent went into the stock market, according to Japanese Finance Ministry data.
Foreigners have kept pouring money into Japanese stocks this year in anticipation that the country's seven-year-old deflation would finally cease. But they are less willing to take currency risks, and analysts say Japanese individuals' buying of overseas assets, driven by higher yields abroad, offset any yen-buying pressure.
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