In order to understand why the yen is weakening, you have to understand its place within the financial system. Because the Bank of Japan has held rates at or near zero over many years, it has been used as a funding currency in carry trades for a long period of time. That relationship changed in early April, soon after Bernanke announced that the Fed was “electronically” printing dollars. From that point, it was the dollar that became the funding currency and as we’ve seen, it was the dollar depreciated as investors took on greater amounts of risk.

Basically, a carry trade means that one currency is being borrowed in order to fund investments in higher-yielding assets, which could be other currencies, government bonds, stocks, or pretty much anything else an investor sees as a good opportunity. Because it’s easy for investors to borrow in any currency, there always will be one currency that acts as a funding source. So the question, going forward, is which currency is likely to be the funding currency of choice.

First, it’s likely that Japan is going to maintain borrowing costs at or near zero because the economy is weak (and figures to remain so, especially as the population ages) and because Japan is still suffering the effects of deflation. Second, just as importantly, the Fed is already making noises about how it plans to withdraw some of the enormous amount of liquidity it has provided.

We already know, as per the December FOMC statement, that many of the emergency liquidity facilities will end during 2010. What’s also been happening is that the Fed is talking about different tools it can use in order to “mop up” the enormous amount of reserves now floating around the system. Basically, when the Fed “sells” it’s withdrawing cash from the system and when it buys (as it did when its balance sheet was greatly expanded) it’s injecting cash into the system.

One tool that the Fed can use to withdraw liquidity is something called a Reverse Repurchase Agreement (known as a reverse repo transaction), which means the Fed sells securities to its dealers while at the same time agreeing to buy them back at some future date.

Another tool the Central Bank has been talking about is a system of Term Deposits, which basically works the same way that a Certificate of Deposit (CD) works at your local bank. In this case, the Fed will offer a certain rate of interest to the large commercial banks when they deposit funds for a specific amount of time, which also has the effect of withdrawing cash from the system.

The point of all this is that going forward, the yen is likely to once again take the role of acting as the main funding currency in carry trades as investors take on more and more risk as the global economy improves in 2010.

Michael Mussa, senior fellow at the Peterson Institute for International Economics, correctly forecasted the economy would be growing at about a 2.7% annualized rate in the 3rd quarter of 2009. What he’s now saying is that the economy could grow by 5% in 2010, primarily because all three government surveys that deal with employment and unemployment in jobs are showing improvement beyond what people would normally expect.

How low could the yen go against the dollar? If Mussa’s scenario was to play out we could easily see the yen fall to around 101 within several months, which is about where it was when the dollar became the main funding currency. Beyond that, I would not be surprised to see 105 later on in the year.