Yen Carry Trade Wanes
The recent turbulence in the global financial markets stemming from the Japanese yen's carry trade unwind seems to have settled down. Reports indicate that approximately 75% of such trades have now been closed out, which was once a major contributing factor to market volatility. This adjustment marks a significant shift in the trading landscape, particularly as major stock markets in both the US and Japan are slowly approaching pre-correction levels. The yen, after experiencing a substantial rally against the dollar, has transitioned into a more stable trading range.
The yuan, another low-interest Asian currency akin to the yen, displayed impressive strength, climbing 2000 points from prior lows, momentarily breaching the 7.1 level against the dollar. Recently, it has stabilized around the 7.15 mark, reflecting a resilient positioning in the currency market. As financial analysts point out, on August 14, the yuan's mid-point exchange rate was set at 7.1415, which was an increase of 64 points, marking the most significant rise since early May 2024. This trend of a stronger yuan appears to signal a shift in market dynamics, as the previous discrepancies between the mid-rate established by the central bank and actual trading rates have begun to converge. This alignment reflects the market's supply-demand forces more accurately, creating potential space for counter-cyclical adjustments in the future.
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According to Gary Dugan, CEO of the Global CIO Office, the reversal of the yen's carry trade has been profound. Many market participants now believe that most of the carry trades have effectively been unwound. The yen's rebound has alleviated some of the earlier weakness, positioning it competitively compared to its average levels over the past five years.
As of August 14, the currency pairs reported include USD/JPY at 146.97 and USD/CNY at 7.1417, whereas the offshore yuan traded slightly lower at 7.1386. The dollar index hovered around 102.295. A week prior, the USD/JPY had dropped to 141.68, demonstrating a rapid depreciation of nearly 4% for the yen against the dollar within just two days, coinciding with a rebound in the dollar index past 103.
The yen's sudden gains triggered a spike in market anxiety levels. Traders historically borrowed low-cost yen to invest in higher-yielding currencies or assets, such as US stocks and dollars. This practice not only led to a buildup of risk but also made the subsequent corrections particularly tumultuous. The repercussions of the Japanese central bank's unexpected interest rate hike just a fortnight ago—surpassing analysts' expectations—coupled with a general downturn in US stock markets, further intensified the closing pressures. The cascading effect caused significant turmoil across the market, causing even traditionally safe-haven assets like gold to face sell-offs during a particularly volatile trading session dubbed "Black Monday."
With the yen calming, overall market sentiment appears to be stabilizing. The Nikkei 225 index has soared to 36,442.43 points, rebounding nearly 17% from its lows just a week prior. Indicatively, the historical inverse relationship between the Japanese stock market and the yen suggests that typically, a weaker yen benefits exporters—companies in industries like automotive, machinery, and tourism often represented as key weighty stocks.
Market experts assert that, following the Bank of Japan's emergency announcement last week indicating no further interest rate hikes this year, the Japanese stock market appears to have found its footing. Dugan remarked that Japanese stocks are still approximately 10% below levels seen prior to the onset of the crisis surrounding Silicon Valley Bank. “While there are ongoing concerns over the yen's recent sharp appreciation potentially impacting profit growth for Japanese firms, we believe the market dip offers a significant buying opportunity,” he noted. Additionally, a 1.1% increase in Japan's real wages was reported in June, which exceeded expectations and indicates positive economic transformation ahead.
This year has marked the first instance in 27 months of real wage growth, with nominal wages increasing by 4.5%—the largest seen since 1997. Combined with decent summer bonuses and potential for further wage increases, overall household financial health is expected to improve, bolstering GDP growth expectations.
Further analysis reveals that throughout the past year, Japan’s stock market has been one of the few where earnings forecasts consistently receive upward adjustments from analysts. This year, approximately 60% of Japanese corporations that reported their second-quarter performances contributed to these upward revisions. With 75% of the carry trades unwound and the yen recovered, the potential impact of the yen's increase on the equities market is likely decreasing, according to Dugan.
Jerry Chen, a senior analyst at Gao Sheng Group, pointed out that the Bank of Japan's recent remarks to avoid additional interest rate hikes during times of market turbulence led to some rebound for the yen after significant declines. Last week, markets saw a candlestick pattern indicating a temporary standoff between buyers and sellers. The critical factor will be whether the substantially reduced short positions in the yen will lead to further liquidations and at what pace these occur.
“Even if the Bank of Japan maintains steady interest rates, the expectations for the Federal Reserve to decrease rates could compress the USD/JPY interest spread. Thus, the pressure on the exchange rate since July may not be easily reversed. Close attention will need to be paid when the pair approaches the 149-151 range, as there is risk for further declines if previous support levels are breached,” Chen remarked.
The pressure on the yuan appears to be easing. Over the past year, there has been a notable correlation between the yuan and the yen. Hedge funds have utilized both as part of a group of low-interest financing currencies, balancing against higher-yield currencies like the Australian and US dollars.
In recent weeks, the onshore yuan has outperformed, maintaining stability under 7.15. In fact, on August 14, the offshore yuan's performance exceeded that of its onshore counterpart, which is a rare development. An FX trader from a foreign bank noted, “Given traders' sensitivity to the signals from the mid-point rates, the People's Bank of China faced difficulties in significantly depreciating the mid-rate when downward pressures were high. The mid-rate has long been held below 7.12, creating a disconnect of over 1000 points from the spot trading prices, leading to the yuan reaching its upper volatility limits. Now that depreciation pressures are easing, modest adjustments to the mid-rate could create space for potential counter-cyclical measures in the future.”
In a statement, the Exchange pointed out, “The PBOC has gradually allowed the daily dollar-to-yuan mid-rate to rise since June (essentially depreciating the yuan). The onshore spot rate has increased and continued to oscillate near the upper limits of allowable daily trading. PBOC Governor Pan Gongsheng indicated a preference for exchange rate stability. Concurrently, disappointing US economic data has fueled speculation regarding future rate cuts from the Fed, suggesting that September's meeting might witness a reduction in rates, thereby eroding the dollar's overall support.”
Further observations indicate that the Chinese central bank does not rule out the possibility of allowing further depreciation of the yuan while maintaining low volatility or flexibility in the exchange rate. From an economic perspective, the benefits of yuan depreciation are clear—including alleviating downward inflationary pressures and offsetting high tariffs on exporters, a crucial consideration given the current recovery's dependency on exports.
In the shorter term, it is suggested that investors adopt a bearish stance towards the dollar against other Asian currencies and increase exposure to risks related to a depreciating dollar. However, there are warnings against making this a central investment strategy, considering the mid-term uncertainty surrounding the dollar's trajectory.
This flourished landscape could shift rapidly as the November 5 US elections approach. Markets typically rally during the months leading up to elections. The shifting economic policies from former President Trump may garner increased attention, especially concerning tariffs that could boost the dollar against trade-sensitive Asian currencies. As such, observers expect the dollar to experience weakness over July and August but strengthen during Q4, with overall currency market volatility likely increasing from its currently subdued state. Additionally, as the Fed is seen leaning toward reducing interest rates, central banks throughout Asia may contemplate similar adjustments in their respective rates, with Korea's central bank being one hypothetical example.
Moreover, the prospects for unexpected emergency cuts from the Fed appear significantly diminished. Kristina Hooper, Chief Global Market Strategist at Invesco, remarked that the disappointing US Job Reports from July, which sparked fears about a potential recession, have negatively impacted market performance. However, it was labor data that seemed to bring some reassurance last week, particularly the figures surrounding initial unemployment claims that came in lower than anticipated. “I believe the Fed is unlikely to implement emergency cuts before the September meeting, as the current environment does not warrant such action. In fact, an emergency cut could result in substantial market panic,” Hooper concluded.