All is not well in the land of the rising sun.

While most investors have kept their eyes glued to American markets over the course of the recession of 2008 and 2009, Japan has been host to its own set of economic problems. And as more eyes turn to the Japanese economy, a potentially profitable ETF play is emerging right before us.

Here’s how you could benefit from Japan’s deflationary woes…

Boom, Bubble, and Bust

More than twenty years ago, Japan was experiencing an economic boom unlike anything seen in a generation. The Japanese car industry was gearing up as a serious competitor to the big three American automakers, and Japan’s tech sector was beginning to find its legs. Ever-climbing Japanese stocks became hugely popular in the financial world, and real estate in Japan rocketed along with them.

By 1989, property prices in Tokyo’s most desirable neighborhoods reached as high as $93,000 per square foot, making it the most expensive city in the world. But that prosperity wasn’t to be long-lived.

Over the course of three days in 1990, Japan’s asset price bubble burst, and the Tokyo Stock Exchange lost $400 billion in value. But that was just the tip of the iceberg. Over the course of the next 14 years, the Japanese economy continued its fall and subsequent stagnation – a period of time known simply as “the lost decade”.

Japan’s problem wasn’t unfamiliar. In the years after World War II, Japan’s fast-growing economy became a hotspot for stock market and real estate speculation fueled by high-risk, subprime debt. When the asset price bubble popped, it caused a chain reaction that put the Japanese economy at a standstill.

In 2007, Japan looked like it was finally regaining economic ground as real estate prices rose for the first time since 1990… then the subprime mortgage crisis happened here in the United States, throwing economies across the world into a tailspin.

Ironically, it was almost the exact same circumstances that lead to Japan’s asset price bubble that ushered in the recession we’re facing today.

Does Deflation Spell Doom for Japan?

But the economic problems facing Japan and the United States are far from the same. That’s because while the U.S. has maintained a moderate rate of inflation for the duration of the recession, Japan is currently on a crash course for deflation.

In essence, strong deflation is the equivalent of pulling the handbrake on the economy.

Unlike inflation, where the buying power of a dollar decreases over time (the reason you can’t buy a McDonald’s hamburger for 15 cents anymore), deflation causes the buying power of money to increase. And while that might sound attractive, the economic consequences of deflation far exceed the benefits.

That’s a serious concern according to Fed Chairman Ben Bernanke and his league of economists. “Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero,” explained Bernanke to Washington D.C.’s National Economists Club back in 2002.

“Once the nominal interest rate is at zero,” he continued,  “…no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash.”

When holding onto cash is more lucrative for lenders than making loans, credit markets seize, and economic activity screeches to a halt. Deflation also means that current debts – like a $300 car payment – become comparatively huge amounts of money to dole out.

“Profits fall, then wages come down, then consumers stop shopping,” Junko Nishioka, chief Japan economist at RBS Securities Japan told Bloomberg. “And because people aren’t shopping, companies lower prices. That’s the process that we’re starting to see. It isn’t easy to break out of.”

Ben Bernanke and the powers that be have made it clear that they’ll do whatever it takes to avoid deflation right now here in the U.S… But that’s not what’s going on in Japan.

The inflation (or deflation) rate is measured by the Consumer Price Index – an index that measures the prices of a basket of consumer goods. As the CPI drops the risk of deflation rises substantially. In May Japan’s main index of consumer prices dropped 1.1%, the biggest decline since 2002. That marks the fifth straight month of price decreases in Japan.

Land of the Rising Yen

Through all of this, the biggest winner has been Japan’s currency, the yen. As deflationary pressures rise, giving each yen more buying power, the currency’s value relative to other countries’ money rises as well.

Since last August, the yen has gained 17.9% against the U.S. dollar and nearly 30% against the Euro, making it one of the most attractive and powerful currencies right now for Forex traders.

That deflation-driven bull market in the Japanese yen has made for an interesting ETF play as well. At present, there are a number of ETFs and ETNs that trade in concert with the ebbs and flows of the yen. Some of the more popular funds include the CurrencyShares Japanese Yen Trust (NYSE: FXY), iPath USD/JPY Exchange Rate ETN (NYSE: JYN), and WisdomTree Dreyfus Japanese Yen Fund (NYSE: JYF).

While each of these funds has a somewhat different investment objective, FXY is the most heavily traded by far, and most liquid.

As you can see from the chart above, FXY’s price action hasn’t been calm and steady, but it has followed an overall uptrend over the course of the last year. After a double top in January, the fund’s price retraced around half of its previous rally before pushing back up. That’s a good sign that suggests shares of the ETF are set to break or at least match the previous high.

Surging volume on upward price movements confirms that investors see the yen pushing up.

FXY looks like it could be finding support on at its 200-day moving average on a pullback. If that happens, it’s time to think about going long on the yen.

While it’s very likely that the Japanese government will step in and attempt to curb deflation before it starts in earnest, their actions won’t be felt until much later in the game. Currencies are very susceptible to politics and world changes, so keep a tight stop on this ETF if you’re considering a short-term trade.

Cheers,
Jonas Elmerraji

July 15, 2009

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

View articles by Jonas Elmerraji