Japan may yet intervene, but don't expect miracles

NEW YORK/LONDON (Reuters) - Traders are on alert for Japanese intervention to weaken the rapidly rising yen but most suspect it will prove about as effective as stepping in front of a moving train.

The Japanese currency has surged 8.0 percent against the U.S. dollar and 17 percent against the euro in October, prompting a warning this week from the Group of Seven most industrialized countries.

G7 officials have dashed expectations for a coordinated move by central banks, but the statement was seen as a green light for Japan to take matters into its own hands, which markets expect it to do if the dollar falls below 90. The dollar last traded up at 97.90 yen.

But analysts warn that these are no ordinary times, noting that the credit crisis is forcing investors who borrowed the yen at low interest rates to buy assets elsewhere to unwind those bets and send the money back to Japan.

"Essentially what you are seeing is a very large unwind of bubbles that were in stocks, bonds, equities, real estate, commodities and emerging markets," said Mansoor Mohi-uddin, chief currency strategist at UBS in Zurich.

"So as these trades are unwound, can the authorities stand in the way of that?"

David Gilmore, partner at Foreign Exchange Analytics in Essex, Connecticut, said singling out the yen exchange rate amounts to "treating the symptom, not the cause."

Until credit starts flowing again and asset prices stop plunging around the world, he said exchange rates will remain volatile.

The yen retreated on Tuesday, falling more than 5.0 percent against the dollar as global stock markets rebounded.

Ashraf Laidi, head market analyst at CMC Markets in New York, said a report from Japan's Nikkei newspaper that the Bank of Japan may cut its already low 0.5 percent interest rate, was more effective at weakening the yen than intervention threats.

But analyst said the move was a brief pause in a longer term trend and predicted renewed yen strength once global asset liquidation picks up speed again.

FORCED LIQUDATION

For Japanese manufacturers, a dearer yen raises the risk of deflation at home because it makes exports harder to sell, especially when the world economy looks headed for recession.

In 2003, yen strength prompted Japanese authorities to sell a record 20 trillion yen, or $204 billion at current exchange rates. They sold another 15 trillion yen in early 2004.

This history of successful intervention means investors should proceed with caution, currency strategists at BNP Paribas said, as does Japan's past willingness to sell yen against both the dollar and euro.

Dennis Gartman, an independent investor and author of the daily Gartman Letter, added that intervening to weaken a currency is easier than trying to prop it up, as authorities can flood the markets with nearly unlimited amounts of money.

If Japan does pull the trigger, the move will have an immediate impact on the exchange rate, said Michael Metcalfe, senior strategist at State Street Global Markets in London.

"But whether that is going to change Japanese investors' attitudes toward bringing money home is less clear," he said. If not, the effect of intervention would likely fade quickly.

While nobody knows the precise amount that's been poured back into Japan, nearly everyone agrees it's been massive.

The exchange rate bears that out. Last Friday, the dollar plunged to a 13-year low below 91 yen after trading around 102.40 earlier in the week -- its worst weekly decline since 1998.

What's more, the moves are being driven not by speculative investors but "by what we would class as forced trades," Metcalfe said, suggesting Japanese authorities would be running up against determined and persistent counterflows.

Also, he said equity managers have begun hedging currency risk by building up forward positions in the yen and U.S. dollar, which has also gained as U.S. investors repatriate money and seek safety in the U.S. government bond market.

Intervention, he said, would have to change investors' risk appetite and stop these repatriation flows to be successful.

Rather than challenge repatriation flows head on, Japanese authorities may opt to "smooth out the market" in smaller amounts when trading volume is light and keep firing verbal volleys at the currency, said Michael Woolfolk, senior currency strategist at The Bank of New York-Mellon.

"I don't think anyone among Japanese policymakers or private banks has a clear idea how much money we're talking about," he added.

"Maybe it's several billion dollars worth of intervention that would be required, maybe it's not. But that's a heck of a lot of money to take a gamble on."

(Reporting by Steven C. Johnson;)