Japan's top currency official gives Paulson the brush off

Yesterday, U.S. Treasury Secretary Henry Paulson got dragged before the Senate Banking Committee to defend his record on the Chinese yuan. Despite verbally pressuring China to let its currency appreciate against the dollar, the U.S. administration hasn't gotten much for its efforts. The yuan is rising, but not by much -- and officials like Republican Senator Jim Bunning let Paulson have it.

What's interesting is that Paulson also said he's watching the yen "very, very carefully." He further implied the yen would be a topic of discussion at a G-7 meeting in Germany just over a week from now. Why so much focus on the yen? Because it's been tanking lately due to the Bank of Japan's wussiness over hiking interest rates. The weaker yen, experts argue, make Japanese exports more competitive versus those produced in other countries, giving the Japanese an "unfair" advantage.

Now here's where things REALLY get interesting. One of the forces driving the "money, money everywhere" phenomenon I keep harping on is the cheap yen. Investors the world over are borrowing cheap yen and using those funds to invest in countries and assets with higher yields. This is known as the "yen carry trade." Should the yen shoot up unexpectedly, it could cause that global trade to unwind, tanking asset prices.

There's no sign of that happening yet, of course. In fact, the Fed basically reinforced the"Party on!" attitude yesterday by playing down "real" inflation and making no mention of excessive asset inflation. And Japan's top currency official, Hiroshi Watanabe, just gave Paulson the brush off, playing down any possibility of a yen surge. But you definitely have to keep an eye on this as a carry trade unwind would result in the markets getting very ugly, very fast.