The surge of the Japanese Yen affects global assets! How powerful is the reversal of arbitrage trading that once fueled the 2008 financial crisis?

As the expectation of narrowing US-Japan interest rate differentials heats up, the Japanese yen has rebounded strongly, causing a massive "liquidation" of arbitrage trades globally.

Today, the yen against the US dollar rate rose to its highest level in two months, with gains also seen against the euro and the pound to varying degrees.

This has triggered fluctuations in asset prices globally:

The yen's appreciation is unfavorable for Japanese exporters, leading to a temporary pause in the rise of Japanese stocks, with the Nikkei 225 index entering a technical adjustment range.

Offshore renminbi rose to its highest level in over a month, surging over 600 points intraday, approaching the 7.2 mark.

While high-yield currencies such as the Australian dollar suffered heavy losses.

As investors begin to embrace the yen, both gold and bitcoin prices have fallen. Spot gold accelerated its decline, dropping sharply from above the $2400 mark, with an intraday decline of 1%.

The decline in bitcoin intensified, with an intraday drop of nearly 4%.

The yen's rise reflects the reversal of yen arbitrage trades as the expectation of narrowing US-Japan interest rate differentials heats up.

Arbitrage trading refers to borrowing low-interest currencies to invest in high-yield assets for profit. Due to the Bank of Japan's long-term maintenance of low interest rates, the yen is often seen as one of the most attractive currencies for arbitrage trading.

For the most popular "sell yen, buy dollars" arbitrage trade in the foreign exchange market, the larger the US-Japan interest rate differential, the greater the profit potential for investors. Therefore, the strength of US stocks and the upward movement of US interest rates often weigh on the yen.

Meanwhile, overnight weakness in tech stocks dragged down US stocks collectively, soft economic data once again boosted expectations of a Fed rate cut, coupled with news of a possible rate hike by the Bank of Japan. With these factors combined, investors have started unwinding arbitrage trades, injecting a dose of confidence into the yen, which has been persistently weak so far this year.Capital.Com senior market analyst Kyle Rodda said: "This is actually a large-scale deleveraging event caused by the short squeeze of the Japanese yen, forcing a widespread liquidation across the market."

Market analysts warned that with the summer market trading thin, if the Japanese yen continues to appreciate, it may lead to cross-asset liquidation, increasing volatility and forced selling.

The Potential "Accomplice" of Financial Crises

Looking back at history, on the eve of the 2008 financial crisis, there was also a phenomenon of large-scale unwinding of Japanese yen carry trades.

Since the collapse of the Japanese stock market in the 1990s, the Japanese economy has been in a prolonged slump for twenty years. To boost confidence, the Bank of Japan has maintained low interest rates for a long time, making Japanese yen carry trades exceptionally active. Japan, as one of the few major creditor nations globally, gradually elevated the status of the yen as a safe-haven asset.

On the eve of the 2008 financial crisis, at least hundreds of billions of dollars were invested in Japanese yen carry trades, with most of the investments in higher-yielding risky assets.

After the burst of the U.S. real estate market bubble, investors rushed to close carry trades, coupled with a large influx of safe-haven currencies, the demand for the yen surged, causing a significant appreciation of the yen. Panic trading behavior further exacerbated the global economic crisis.

With the global economic recession, the appreciation of the yen was even more detrimental to Japan's export-oriented economy, ultimately making Japan the worst-performing country among the G7 economies.

How Powerful is the Reversal of Carry Trades?

The International Monetary Fund (IMF) has released a report studying the relationship between Japanese yen carry trades and the subprime crisis. The report points out that the unwinding of Japanese yen carry trades often leads to fund outflows, triggering a global decline in asset prices, and as financial institutions deleverage, it will lead to credit tightening.

Specifically, the impact of unwinding Japanese yen carry trades is mainly reflected in the following aspects:

Asset Price Volatility: The unwinding of Japanese yen carry trades leads to funds being withdrawn from high-yielding risky assets, which usually triggers a decline in asset prices.

Change in Risk Appetite: The "fear index" VIX is negatively correlated with the scale of Japanese yen carry trades. When market participants expect low risk and high returns, the scale of Japanese yen carry trades increases, which in turn increases the market's demand for risky assets.

Deleveraging during Crisis Periods: When market conditions deteriorate, such as during the subprime crisis in 2007-08, the unwinding of Japanese yen carry trades is part of the process of financial institutions deleveraging. Financial institutions have to reduce the size of their balance sheets by selling assets and repaying debts to reduce risk exposure.

Credit Market Tightening: When financial institutions start unwinding Japanese yen carry trades, they need to reduce leverage by selling assets and repaying debts, leading to reduced liquidity in the credit market and further tightening of credit conditions

Subprime Crisis Intensifies: As financial institutions unwind their arbitrage trading positions, the prices of subprime-related assets further decline, exacerbating credit market tightening and financial institutions' losses