From a sharp decline to a sharp rise, has the alarm been lifted?

In the past few days, the global spotlight has been on Japan, where the Japanese stock market went from ICU to KTV in just one day.

The logic chain that triggered the global asset sell-off a few days ago was as follows:

The Bank of Japan raised interest rates, causing the yen to appreciate --> Carry trades borrowing yen to buy high-yield assets were unwound --> US and Japanese stocks plummeted --> Safe-haven sentiment led to yen appreciation --> Self-reinforcing process accelerated --> Hedge funds and trading departments faced Var Shock and were forced to close out other positions --> All popular trading positions were forced to unwind --> Triggered a liquidity crisis.

In the meantime, the recession expectations triggered by US employment data further accelerated this chain of events.

How to break this cycle?

1. The key lies in the hands of the key players. First, the central bank needs to come out and speak to soothe market sentiment.

2. A good set of US data is needed to reduce market concerns about a US recession, pulling back excessive rate cut expectations.

3. Clean up positions. When various popular trade positions are almost squared, this wave will come to an end.

Based on the market performance from yesterday, the above three conditions were met:

1. The Japanese Ministry of Finance, the Bank of Japan, and the Financial Services Agency held a trilateral meeting to discuss the severe volatility in the Japanese stock and foreign exchange markets. After the meeting, a senior official from the Japanese Ministry of Finance came out to speak, stating that the authorities will continue to calmly assess the situation, the government will continue to cooperate with the Bank of Japan, and take all possible measures for economic and fiscal management.

2. The US finally received a good set of data. The July ISM Non-Manufacturing PMI rebounded from 48.8 to 51.4, higher than the expected value of 51. Moreover, all sub-indices were very good, with the new orders index rising from 47.3 to 52.4, and the employment index rising from 46.1 to 51.1.

3. In terms of the size of Carry trade positions, different foreign institutions have given different opinions. Yesterday, a GS research report stated that after a month of unwinding, JPY positions have turned positive; however, JPM stated that only half of the yen carry trades have been unwound.

The crisis alert has been temporarily lifted, with Japanese stocks rebounding and hitting an upward circuit breaker, USDJPY rising above 145, and the 10-year US Treasury yield increasing by 10 basis points to 3.89%.

Market Outlook

1. Currently, US dollar liquidity is very tight. The "reservoir" of liquidity in ON RRP (overnight reverse repurchase) continues to decline, falling to $291.958 billion on Tuesday, the lowest since 2021 The tight liquidity of overseas US dollars has also transmitted to the domestic market, as seen in the significant drop in short-term swap points for USD/CNY from T/N to within 3 months.

1. Currently leaning towards being long on the USD, expecting the US dollar index to return above 104.

1. In the case of tight US dollar liquidity, the dollar will not be too weak;

2. Currently, there is a bias towards a 106 basis point rate cut by the Fed within the year, while the ECB's rate cut expectation is only 66 basis points for the year. The pricing of rate cut expectations in Europe lags behind the United States, and the future adjustment of interest rate differentials between Europe and the US will be negative for the EUR.

1. In the current high volatility environment, it is difficult for the Carry trade to return in the short term. The foreign exchange market remains in a wide-ranging volatile trend, increasing the difficulty of trading. It is expected that USD/JPY will fluctuate in the range of 143-149, corresponding to USD/CNH in the range of 7.10-7.20.

Author: Fang Yuqi, Source: Good Morning Market, Original Title: "From Plunge to Surge, Has the Alarm Been Lifted?"