The U.S. dollar-Japanese yen exchange rate endured one of its most turbulent weeks in recent years, with sharp swings driven by pivotal economic events that have left traders reassessing the future of the dollar-yen carry trade.
The USD/JPY pair opened the week at 146.36, but quickly plunged to a low of 141.68 on Monday as traders fully priced in a 50-basis-point rate cut by the Federal Reserve in September, with some even speculating on an emergency intermeeting cut.
The dollar rebounded against the yen later in the week, buoyed by dovish remarks from the Bank of Japan (BoJ) and U.S. economic data that pushed back against fears of an imminent recession.
By the end of the week, the yen, as tracked by the Invesco CurrencyShares Japanese Yen Trust FXY, has largely remained unchanged from its previous week’s close.
This volatile week has traders questioning how much carry trade positioning is left in USD/JPY and whether it’s time to re-enter the long dollar-short yen trade as a hedge against potential U.S. inflation surprises, or if shorting USD/JPY might be a more effective strategy to guard against a possible recession.
Adam Turnquist, chief technical strategist for LPL Financial, explained that “ultra-low rates and easy monetary policy made the yen an attractive funding currency for the carry trade,” where investors borrow in low-yield currencies like the yen to fund investments in higher-yielding securities elsewhere, such as U.S. Treasuries.
However, recent tightening measures from the BoJ have “pulled the proverbial thread on this crowded trade, and it started to unravel,” sparking a surge in yen buying as investors covered short positions.
According to Turnquist, estimating the size of the yen carry trade is challenging due to the opaque nature of currency positioning and transactions. The overall yen borrowing could range from $1 to $4 trillion, with recent reports suggesting that 75% of carry trades have been closed following this week’s volatility events.
Turnquist indicated USD/JPY is no longer on an uptrend, implying that the risk of additional downsides remains elevated.
It’s too early to consider the recent rebound as anything more than a “relief rally off oversold levels.” He stated that a close below the 141 support level could signal another potential leg lower, while a rally above 152 would suggest a return to the previous uptrend, reducing carry trade volatility and downside risk.
David Morrison, senior market analyst at Trade Nation, observed that the USD/JPY pair hit its lowest level since the beginning of the year on Monday but has since rallied nearly 4%, indicating that the market has “steadied and most of the unwinding has been completed.
However, Morrison cautioned there is still concern that “there could be more unwinding of the yen carry-trade to come.” If this occurs, it could lead to further yen strength, accelerating the unwinding process and putting additional downward pressure on risk assets.
Morrison also noted that the BoJ released minutes from its latest monetary policy meeting, where it unexpectedly tightened policy. Although the minutes suggested that further rate hikes could be on the horizon, the market largely ignored this as dovish comments from the BoJ’s deputy governor “effectively neutralized the minutes.”
Shusuke Yamada, a foreign exchange analyst at Bank of America, suggested that much of the short-term yen carry-trade unwinding “has run its course” based on positioning measures and signs of stabilization in equity markets.
However, Yamada warned that “cyclical hedgers would sell USD/JPY’s rally to hedge against a U.S. hard-landing scenario.”
Yamada also highlighted structural outflows, such as corporate foreign direct investment (FDI) and retail investors’ outward equity investments, “remain intact” as these trades are not driven by short-term interest rate differentials.
Bank of America has revised its end-2024 USD/JPY forecast to 155 but maintains a “structurally bearish yen view.”
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