The Japanese yen has historically been considered as a barometer of risk appetite in the FX market. True to form, it has strengthened as bouts of risk aversion have hit financial markets. Recently, the yen reached 15-year highs and has rallied more than 10 per cent in 2010, prompting official intervention for the first time in six years. So as the recovery shows signs of fading, will yen strength continue despite a litany of Japanese economic problems?

Japan’s historically high savings ratio and surplus on its current account are behind the safe-haven perception of the yen. But the unwind of carry trades seems a more likely explanation of the yen’s current strength rather than it being seen as a true store-of-value asset. Unwinding could be interpreted as a move to avert risk since investors are unwinding a riskier trade and seeking to protect themselves if risky assets decline.

The accommodative monetary environment is likely to place downward pressure on the yen in the coming months as the global recovery path becomes clearer and as interest rates rise and differentials potentially widen.

Japan’s unsterilised currency intervention is effectively a decision to pursue an indirect form of quantitative easing. A more diplomatically palatable solution could be for Japan to introduce its own direct QE programme, thereby debasing the yen in a similar fashion to the US dollar and not raising the ire of the US anti-intervention lobby.

With an export-driven economy, a strong yen is a thorn in the side of Japanese exporters and was partly behind the currency intervention. Additionally, growth is faltering and the government’s debt position is the highest in the OECD and politically Japan is a rudderless ship – it has had five prime ministers in the past five years.

Futures market positioning and options pricing confirm the bullish market view of the yen. But investors using exchange-traded currency products show a starkly contrasting view, with over 35 per cent of ETFS’ assets under management held in short positions. The yen’s real effective exchange rate (REER) is over 10 per cent above the longer-term average and the valuation looks stretched given the underlying fundamentals.