In May of 2013 I issued a trading recommendation to sell assets tied to the Japanese yen. Since then, ETFs like the CurrencyShares Japanese Yen Trust (NYSEMKT:FXY), which tracks the value of the yen against its most commonly traded counterparts, has fallen by 4.2%. Even against the U.S. dollar, which has shown a period of prolonged weakness in its own right, the yen is currently trading at its lowest levels in five years, having fallen by about 5% in relation to the dollar since the May recommendation was given. Some of these declines in the Japanese currency can be explained by the fact that stable growth at the global level has allowed currency investors to use low-yielding currencies to fund positions in higher-yielding currencies (a practice called the "carry trade"). The yen is generally used as a primary vehicle for these types of positions, therefore so long as global GDP growth quickens, these trends are unlikely to reverse anytime soon.
Bank of Japan likely to continue stimulus
But the drivers of this past year's yen weakness do not stop there. Radical stimulus programs enacted by the Bank of Japan were larger (by percentage of annual GDP) than the quantitative-easing measures implemented by the U.S. Federal Reserve. And now that the Fed has committed to an exit strategy -- i.e., started "tapering" -- the Japanese economy could be considered "behind the curve" in terms of how its stimulus programs are likely to progress relative to its developed-market counterparts. Monetary injections tend to have a bearish effect on the value of a currency because there is a larger supply of that currency running through the system. Because the Fed has enacted a plan to cut back on stimulus injections and the BoJ shows no signs of slowing down anytime soon, investors can expect dollar-based ETFs like the PowerShares DB US Dollar Index Bullish (NYSEMKT:UUP) to continue to outperform their Japanese counterparts well into 2014.
Prospects for export companies
Japan's central-bank policy measures aiming to reverse decades of deflation and put downside pressure on currency values are having another effect: boosting the earnings outlooks for Japanese export companies. Despite its developed-market status, Japan is still an export economy, and a weaker yen will help prop up analyst earnings projections for companies that depend heavily on foreign sales. This year's declines in the yen have helped generate massive rallies in the Nikkei 225, which is up 52% over the past year.
Gains of this magnitude have not been seen in more than four decades. So, as long as we see commitments to stay the course at the BoJ, ETFs like the iShares MSCI Japan Fund (NYSEMKT:EWJ) should remain elevated relative to multiyear averages. For investors looking to gain (or avoid) exposure in Japanese assets, it is important to remember that the current policy strategy implemented by the BoJ offers strong positives for the country's benchmark stock index and strong negatives for assets most highly correlated with the value of the yen.
Going forward, it will be important to monitor consumer price inflation in Japan in order to determine whether or not these trends are likely to continue. Consumer inflation rates for 2013 are expected to come in near 1%. This is well below BoJ's 2% target rate. So, until we see more material progress in this area, the BoJ will continue with more of the same in 2014. This means continued pressure on currency values and support of stock values for the country's exporters.
Richard Cox has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.