By Shinichi Saoshiro
TOKYO (Reuters) - The Japanese yen's recent rise against the dollar has defied conventional market wisdom, but a stronger currency may actually support Japan as it confronts the Trump administration on matters of trade and foreign exchange.
The Federal Reserve's explicit plan to raise interest rates this year, in stark contrast to the Bank of Japan's persistently accommodative monetary policy, should in theory be a reason for investors to move out of the yen and seek yield in the greenback, the so-called carry trade.
However, growing investor doubts over President Donald Trump's economic stimulus plans have hurt the dollar in recent weeks. Meanwhile, Japanese Prime Minister Shinzo Abe, now in a rare fifth year as leader, is battling scandals on two separate issues, driving funds into the safe haven yen.
While a stronger yen is typically bad news for Japan's exporters, it provides some reprieve for an economy that the United States has accused of exploiting a cheap currency for growth.
"The Japanese authorities are aware of these trade threats and have been proactive in trying to manage the relationship with President Trump," economists at Oxford Economics said in a report earlier this week.
And if the idea of a weak yen becomes a point of contention between the two countries, Japan could guide the yen to be stronger than Oxford Economics' baseline projection of 118 to the dollar, they said.
The yen <JPY=> is now around 111 per dollar, the highs last seen just after Donald Trump was elected U.S. president in November. It hit 110.735 on Wednesday, its highest since late November.
Analysts expect the yen to remain strong.
"Dollar/yen should be around 114 considering current U.S.-Japan yield spreads, but it has drifted down to 111 on worries over political risks," said Yukio Ishizuki, senior currency strategist at Daiwa Securities.
Ishizuki expects the dollar's value will fall towards 110 yen in the next three months, occasionally even dropping below that threshold.
The yen's rise comes conveniently just weeks before U.S. Vice President Mike Pence's visit to Japan and meeting with Deputy Prime Minister Taro Aso, who doubles as Japan's finance minister, to discuss bilateral economic issues.
Japan's large trade surplus with the United States has stirred fears that the Trump administration might press for a stronger yen. Data on Wednesday showed Japan's exports to the United States grew the most in roughly two years in February.
"There appear to be concerns about the feasibility of U.S. policies going forward," said Shusuke Yamada, senior strategist at Bank of America Merrill Lynch in Tokyo, referring to the dollar flagging against the yen.
"Wariness that Trump won't tolerate a stronger dollar, for example a rise by the currency to 120 yen, also seems to be limiting the scope for the dollar to gain against the yen." Yamada said.
In theory, the yen should be weaker. Yield differentials between U.S and Japanese two-year bonds were at 1.6 percentage points earlier this month, their widest since August 2008.
The U.S.-Japan long-term yield differential rose above 2.5 percentage points in December, its widest in seven years, and has remained close to that level.
The tentative revival of interest in carry trades, in which investors borrow cheap currencies such as the yen at low rates and invest in assets that offer higher returns, should also technically weaken the yen.
As Abe faces questions on his ties to a nationalist school involved in a murky land deal and his defense minister faces calls to resign, political uncertainty is an added risk.
Japanese retail traders are betting against the yen and have tripled their long dollar positions over the span of a few days according to some trading platform providers.
And, the dollar's woes may reverse if concerns about Trump's policies abate. Investor confidence in the dollar faces a crucial test later Thursday when Trump's own party votes on the government's healthcare legislation, a rejection of which could delay tax reform and the infrastructure boost.
(Editing by Vidya Ranganathan and Sam Holmes)