USD/JPY continues to lose ground, hitting new annual lows. A recent bearish impulse from ¥147.21 adds to a 13.5% fall from highs of ¥161.95 in July. High volatility and negative momentum in the pair have raised concerns about a rapid unwinding of carry trades.
Carry trade operations
Carry trades involve borrowing low-interest currencies, like the Japanese yen or the Swiss franc, to invest in other assets, assuming currency risk. If these currencies appreciate strongly, it could trigger a rapid unwinding of these trades, increasing volatility. The Bank of Japan's (BoJ) low interest rates have fuelled carry trades, with an estimated $4tn in Japanese investments abroad.
Contrary monetary policies weigh down USD/JPY
The weakness in USD/JPY has been reinforced by contrasting monetary policies between the US and Japan.
The US Federal Reserve is expected to start cutting interest rates at its monetary policy statement on 18 September, with a 59% chance of a 50-basis-point cut currently priced in. Meanwhile, the BoJ has begun a cycle of interest-rate hikes that it could tactically pause, but which it is not prepared to abandon outright.
Key policy updates from Fed chair Jerome Powell on Wednesday and BoJ governor Kazuo Ueda on Friday could either deepen USD/JPY's decline or trigger a rebound, impacting carry trades.
A sensitive Japanese stock market
The reversal of carry trades involves repaying debt contracted in yen at lower interest rates, leading to a stronger yen. This appreciation makes Japanese assets more expensive, reducing demand and lowering the income and profits of major exporters. As a result, the Nikkei 225 is closely linked to USD/JPY movements and is sensitive to changes in the pair.
The yen's recent appreciation hasn’t significantly impacted the Nikkei, though tension remains. Although volatility is decreasing, it remains high, and the index is below the 200-day simple moving average. Selling pressure could intensify if it breaks below support at 35,121.
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