JAPAN’S return to growth for the first time since the first quarter of 2008 ought to have been cause for celebration in the markets. Hot on France and Germany’s heels, Japan grew 0.9 per cent in the three months to June on the previous quarter, putting the annual rate at 3.7 per cent.<br /><br />But even a return to positive territory wasn’t enough to satisfy the markets, which had on average forecast slightly better growth figures of 3.9 per cent year-on-year, and gloom descended over the stock markets. Risk appetite flew back off the table as quickly as it had arrived on the back of the Western European data, pushing the Japanese yen and the US dollar higher against riskier currencies such as the Australian dollar.<br /><br />The yen managed to hit its highest levels this month on Monday against both the US dollar and the euro in the wake of the disappointing GDP data.<br /><br />The Japanese yen hit ¥133.20 against the euro – its highest in two weeks, while it touched ¥94.63 against the greenback, before retracing some of the gains yesterday as there was profit taking in equities and weak revival in risk appetite on the back of the rising crude oil price.<br /><br />But the Japanese yen will continue to rise at the expense of risky currencies through the second half of the year. This is for two key reasons.<br /><br />Firstly, there are growing signs that the rally in global equities is starting to run out of steam. After such a bullish run across all markets during late June and early July, traders and investors are starting to worry that the sharp advance in indices has occurred too fast and run ahead of the fundamentals. The response to the Japanese data indicates just how ready the markets are to take profits and drive equities lower. With the Japanese yen inversely correlated with stocks and oil prices, an autumnal dip in the markets will boost the yen further and see carry traders sidelined.<br /><br /><strong>DECIDEDLY OVERVALUED</strong><br />Ilya Spivak, currency analyst at Daily FX says: “Short term (30-day rolling) correlation studies reveal the yen’s average value against a trade-weighted basket of top currencies is now -90.4 per cent inversely correlated with the MSCI World Stock Index. This means that the yen is likely to strengthen if stocks should reverse lower.”<br /><br />He adds: “Global markets ended July trading at the highest level relative to earnings since October 2003 – a year when the global economy grew 2.7 per cent in real terms – making them look decidedly overvalued at present considering the kind of earnings growth that can be expected in year when real world GDP is set to shrink for the first time in the post-war period.”<br /><br />Secondly, investors are still bearish about Japan’s ability to post a strong and sustainable recovery and expect deflation to remain present for the foreseeable future. Intuitively you would expect such a view to weaken the yen, but hopes for a global economic recovery are dependent on Asia leading us out of recession. A gloomy outlook for Japan, one of the world’s largest exporters and the most advanced economy in Asia, will scupper such optimism and see investors return their assets to the safe-havens of the US dollar and the yen. <br /><br /><strong>VICIOUS CYCLE</strong><br />And it is here that the vicious cycle begins. Lombard Street Research’s Michael Taylor notes that the contribution of net exports to real GDP in the second quarter was a very substantial +1.6 percentage points, thanks to traders regaining their appetite for risk during those three months, which caused the yen to ease and boosted exporters’ profitability. The composition of the GDP expansion in the second quarter showed that the improvement was almost exclusively the result of a 6.3 per cent rebound in exports from the first quarter.<br /><br />Export-dependent Japan cannot suffer a strong yen for a sustained period of time as it reduces its industry’s competitiveness and hampers economic growth. But the longer that Japan is unable to convince the markets of a strong and sustained recovery – such an event would require a substantial and speedy pick up in Western consumer spending which will not occur while unemployment continues to rise – the more likely it is that the yen will rise and hit exporters hard once again.<br /><br />Currency traders wanting to go bullish on the yen should choose sterling-yen or Australian dollar-yen (a reverse carry trade). Sterling is seen at the moment as a risky trade and recent comments by the Bank of England have left it vulnerable.<br /><br />The pound was one of the hardest hit by the worse-than-expected Japanese data on Monday morning. The Australian dollar needs support from an Asian recovery thanks to its raw material exports to China. A more bearish outlook for the region ought to see the Aussie dip lower.<br /><br />Japan may not be heading for a second lost decade, but its current weakness does not give investors and businesses cause for optimism in the medium-term. And the perverse nature of the Japanese currency means that in such circumstances, the yen will be more desirable than ever.