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Dollar-euro? It's the yen, stupid

The greenback may be hitting record lows versus the euro but the more worrisome problem - a big drop against the yen.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- The dollar hit a record low against the euro this week, but the bigger story for many currency watchers was the greenback's slip against the yen.

That's because a sharp rise in the yen could have nasty consequences for millions of investors around the world.

The dollar slid to a one-month low of ¥120.96 yen on Wednesday, raising concerns that a strengthening of the Japanese currency could put billions of dollars worth of low-cost yen loans in peril.

The yen rallied a sharp 2 percent over two sessions early this week - its most notable strength since it rallied about 4.5 percent over two weeks starting in late February, according to Ashraf Laidi, chief analyst at CMC Markets in New York.

Since then, the currency has given back some gains against the dollar, which was trading at ¥122.05 in New York Friday. And for the year, the dollar is still up about 3 percent against the yen.

But this week's jump in the yen still rattled Laidi and other currency traders and analysts.

For years, investors have been borrowing at Japan's super-low interest rates and selling yen to buy investments in higher-yielding currencies - a trading bet known on Wall Street as the "yen carry trade."

A big, sustained rebound in the yen could jeopardize those trades, Laidi said. "The yen is a funding currency. When it rallies, it makes the repayment of those yen loans more expensive, even though interest rates are low," he said.

Traders attributed the yen's jump against the dollar this week to problems in the subprime mortgage market in the United States, which caused some investors to seek safer places for their assets - and exit the yen carry trade.

"The carry trade took a bit of a knock earlier in the week when U.S. credit markets were going a bit crazy and equities were tumbling," said Richard Franulovich, a senior currency strategist at Westpac Banking in New York.

That effect was short-lived as stocks stabilized and bullish investors sent the Dow industrials and S&P 500 to new highs Thursday.

Of course, it isn't just U.S. conditions that influence the yen's movement against the dollar. Stronger economic growth in Japan could also lend more support to the yen in the longer-term.

Japan's gross domestic product, the broadest measure of a nation's economic activity, grew at a 3.3 percent annual rate in the first quarter, bolstering expectations for higher interest rates ahead. Higher rates would tend to make Japan more attractive to investors, bolstering the yen.

Japan hiked rates from near zero about a year ago but it's been easygoing since then. Rates currently stand at 0.5 percent, although the Bank of Japan is widely expected to raise them again next month. In comparison, the Federal Reserve is expected to keep holding rates steady, as it has for the last year, for some time.

With growth picking up and rates heading higher, Japanese retail investors could start to feel more confident about the economy and divert their savings from overseas investments to domestic stocks, analysts said.

That could boost the yen and remove support for the carry trade, since it isn't just hedge funds borrowing yen and using the proceeds from yen sales to invest overseas, but also everyday Japanese investing their money in foreign bonds and other assets.

The great concern is that if everyone tries to unwind the carry trade quickly that could slow a tide of money that's helped drive a record boom in private equity buyouts and push stocks higher worldwide.

But such an unwinding - if it happens - wouldn't necessarily trigger hard and fast movements in the markets, some say.

"I think it is difficult to make strong statements about what is happening with regards to the carry trade," Paul Donovan, chief global economist at UBS in London, said. "To the extent that 'carry trades' involve retail investors, this is not an agile trade that turns in a course of a week."

So even though the dollar is at an all-time low against the euro, its movement against the yen may be what bears closer watching.  Top of page