By the looks of it, industry insiders are becoming more and more aware of what really drives global markets - foreign exchange. As the global economy grows stronger, countries become more tightly linked to one another. And that link is based entirely around money changing hands - or, in other words, foreign exchange. The volatile way in which financial markets around the world have been behaving lately can be chalked up to bad loans and collapsing credit. A key driver behind the seemingly unlimited availability of money is once again, foreign exchange.

How bad is the situation in the U.S. financial system? Well let's put it this way: Jeopardy, the popular TV quiz show, is about the only place you could make money by taking shares of the United States.

I'll Take 'Shares of United States' for US$500, Alex.

The appeal of the U.S. is fading fast. At the end of last year, the fundamental backdrop for the U.S. included depressing figures like:

• Trade deficit of US$765.3 billion
• Current account deficit of US$856.7 billion (a not-so-small 6.5% of GDP)
• A gross national debt of US$8.5 TRILLION and still rising
• Exploding supply of money and credit

It's now October. The year is winding down, and the situation doesn't seem to be getting any better. So like most analysts, you may be asking yourself: What's going to happen next, especially if you think that shares of the U.S. don't really exist?

Well, in a way, they do exist, and you can capture these "shares" by investing in the U.S. dollar.

 

Think of a country's currency as simply a share of stock in that country, with values fluctuating depending on the perceived investment potential of that country. Targeting the fundamentals is the same whether you're trading shares of a company or currency of a country.

So as an investor, do you usually look to buy companies with pathetic earnings? Do you want the companies that are drowning in their own debts or can't keep their books in the black? No, of course not. You want companies that have control of their balance sheets and have growth potential.

Same goes for the currency markets. Trades are made depending on how investors perceive a country's fiscal and economic health. Countries whose economies are very promising attract investment capital. And their currencies, like shares of stock in a bull market, reflect that increasing value.

Borrow Low, Lend High

I'm sure you've heard the expression "Buy low, sell high." It makes sense if you're trying to earn profits in any market.

But there's another expression: Borrow low, lend high. Borrowing low and lending high is a strategy that banks have used for quite some time. It's what their business is based around. And it's a very simple and effective way to profit.

Imagine you paid 4% to borrow US$1,000. Then you loaned US$1,000 dollars and charged 6% interest. You're easily sitting on a 2% profit of US$20 (6% interest earned of US$60 minus 4% cost to borrow of US$40). But with banks, these transactions are much larger and more frequent.

Currency participants, institutional and individual investors alike, have been wrapped up in this same banking strategy. It's become so heavily focused upon that they've even given it a name. You've likely heard of it - the carry-trade.

The Carry-Trade Lives...and Dies

Unless you've been hiding under a rock, or have recently returned from a summer-long vacation, you're probably aware of the recent credit crunch that has spooked global markets.

Stemming from bad U.S. sub-prime mortgage loans, the unstable credit market has driven a large number of investors to run for cover. These fleeing investors have taken whatever funds they could salvage with them.

A clear sign of liquidation can easily be seen by monitoring the value of the Japanese yen. As
I've told my readers many times before, interest rates in Japan are low - very low. And investors have taken advantage of these low rates by enacting the "borrow low, lend high" strategy I talked about earlier.

But instead of making loans, they're actually making investments in assets that return a much greater yield than the 0.05% it costs to borrow yen. This is the carry-trade and it's led to a beaten and battered Japanese yen. (Recall that borrowing yen effectively pushes the value of yen lower.)

Score Big from the Coming Yen Appreciation with the Right ETF

The Japanese currency is currently the most undervalued major currency versus the dollar.
Prior to its recent rally, the yen was about 30% undervalued against the buck. That's a serious undervaluation and signals to me that a change is coming.

It looks as though the yen has begun to reverse course as carry-trade money flows back where it came from - Japan. Japan's economy is looking stronger all the time too.

You see, Japan is still recovering from a 14-year bear hug of deflation which began in 1989.
However, there are strong signs the economy is recovering. In fact, Japan grew at a 3.1% pace in the first quarter of 2007. So Japan grew at one of the fastest rates among the world's major industrialized countries (the U.S. grew at only a 1% pace, while the Eurozone grew at just 2.1%).

Once Japan kicks its economy into overdrive, it will be liftoff for this Far East nation's currency.

To make the most of what I anticipate will be a massive yen appreciation, I like the CurrencyShares Japanese yen ETF (FXY). This currency exchange traded fund gives you all the benefits of any normal ETF (diversification, low fees), plus you gain exposure to the profit windfall that's headed for Japan.

 

 

The Rydex CurrencyShares ETFs are fairly new to the scene, so price data for the CurrencyShares Japanese yen only goes back to February of this year. As you can see from the above chart, FXY is testing the high point it set in March. A clear breakout from these levels should bring on more buying and push FXY surging higher.

Jack Crooks is editor of World Currency Options, a weekly research service. The former Currency Director for The Sovereign Society, Jack now serves as a currency consultant.