Has the strengthening of the Japanese Yen become a major "surefire trade" of the year?

According to a market strategist, in the coming months, the US dollar against the Japanese yen may continue to decline, especially with the "carry trade" of the yen potentially having significant upside.

Geoffrey Yu, Senior Market Strategist for Europe, the Middle East, and Africa at Bank of America Merrill Lynch, stated on Wednesday that the weakness of the US dollar against most major currencies is expected to continue until the end of the year.

His comments came after the US dollar faced another round of selling on Tuesday, with market participants awaiting the preliminary revised non-farm payroll figures for March 2024 later in the day. Analysts at ING Bank stated that this data could pose "downside risks" to the US dollar.

Previously, the US dollar against the Japanese yen fell below the key level of 145 yen since January 6, indicating a significant reversal in carry trades in recent weeks. Carry trade refers to investors borrowing in low-interest rate currencies and then reinvesting the funds in other higher-yielding assets.

In recent years, this forex strategy has been very popular, especially when investors expect the yen to remain low while Japanese interest rates stay low.

When asked how low the US dollar against the Japanese yen could fall, Yu replied, "Pick a number, we'd be happy to see it drop to the 130 level, at least by the end of the year, so there is still significant downside potential."

He added, "Based on our data, the yen is still significantly undervalued. I believe that the euro against the dollar at 1.05 may be a more reasonable level, although by current standards, this is still very aggressive. But that will be my target by the end of the year, as the data is indeed starting to show negative changes. However, the US dollar against high-yield currencies, such as the Mexican peso, I think the dollar will actually perform well**."

Since the Bank of Japan raised interest rates earlier this month, the yen has strengthened, leading to a sharp reversal in global markets and carry trades. Strategists have been reluctant to give a clear signal on the rapid unwinding of carry trades, warning investors that the reversal is far from over.

Yu from Bank of America Merrill Lynch also expressed this view on Wednesday, saying, "Our data shows that there are still a lot of short positions on the yen in the market, and we did see a surge in yen cash demand and liquidity demand in early August, but this has largely stabilized." He added:

"I think once the Fed's rate cut path is fully priced in, we will face the issue of the change of government in Japan, which could trigger further unwinding of carry trades, but it won't lead to the kind of drastic volatility we saw two weeks ago."