Because there are really very good reasons to forget the dollar for some time as a carry trade vehicle, I thought it would be helpful to take a closer look at Japan and the yen.

Be careful, investing in Japan and the yen means completely the opposite of using the yen as a carry trade vehicle or “shorting” the yen.

International investors should be cautious about the yen but the risk takers could consider it their best carry trade vehicle for the foreseeable future.

The continued growth of the Japanese fiscal deficit, warnings from the ratings agencies, an underperforming economy, deflationary pressures along with coded messages about official intervention in the foreign exchange markets represent a good reason to steer clear of the yen for investment.

In recent years, government bond yield differentials have helped to determine the performance of the yen crosses like the U.S. dollar/yen, Canadian dollar/yen, Australian dollar/yen, etc..

It is interesting to note how since the start of December, the yield differential between benchmark 10-year Canadian government paper (recently at 3.56 percent) and the 10-year Japanese equivalent (recently at 1.34 percent) has widened by about 25 basis points to the 2.25 percent range, a gap we’ve not seen on a sustained basis since early 2008.

Similarly, the Australian/Japanese yield gap on government paper has widened by about half a percent over the past month to 4.32 percent recently while the U.S./Japan gap has widened by a similar amount recently to 2.43 percent.

For the U.S. and Australian dollar, these yield gaps are reminiscent of those prevailing during the height of the carry trade in 2007 and 2008.

But, it’s not only government bond yield gaps that are undermining the yen.

Concerns also have mounted over the past year about Japan's credit status.

Five-year Japanese government debt credit default swaps (CDS) have consistently underperformed those on the equivalent paper elsewhere.

Five-year Australian sovereign debt CDS have fallen from 125 basis points in late January 2009 to about 38 basis points recently, while the equivalent CDS on Japanese government paper has widened from 35 basis points this time last year to 67 basis points.

Investors should not overlook that even the United States and the United Kingdom having seen a moderation in the cost of the credit default swaps on their sovereign debt over the past twelve months.

This is not an overstatement, but we can easily speak of a clear deterioration in the assessment of Japan’s creditworthiness.

Yes, this is good for carry traders and those who’d like to “short” the yen, but bad for investors in yen-based investments.

The unattractive Japanese yields and the slowly deteriorating credit status of Japan will further motivate international investors to reduce their exposure to Japanese and yen denominated, or fixed, instruments.

In contrast, we’ll see further attractiveness developing in currencies such as the Australian dollar, Canadian dollar and even the U.S. dollar, compared with the yen-denominated government and similar bonds.

Besides that, none of the forces that have been driving the yen lower recently are short term in nature.

Bottom line: I expect sharp upward moves in the yen crosses, which means a weaker yen.

Yes, shorting the yen could prove one of the interesting moves during the first quarter and even beyond this year.