The Bank of Japan unexpectedly "dovish", causing the Japanese Yen to plummet! However, the possibility of "arbitrage closing" may still stir up waves again

According to the financial news app Zhitong Finance, Shinichi Uchida, Deputy Governor of the Bank of Japan, unexpectedly made a dovish speech on Wednesday, emphasizing that if the financial markets are unstable, the policymakers of the Bank of Japan will not further raise the benchmark interest rate. Subsequently, the yen exchange rate experienced a cliff-like decline, with the US dollar against the yen surging by more than 2.5% on Wednesday, indicating a significant devaluation of the yen after days of sharp appreciation due to arbitrage unwinding, and global stock markets received a boost from Uchida's dovish remarks and the depreciation of the yen.

After Shinichi Uchida unexpectedly made the above-mentioned dovish remarks on Wednesday, the yen exchange rate once devalued to 147.90 yen per US dollar, then narrowed its decline slightly, and finally settled around 146.81 yen on Wednesday. In the early Asian trading session on Thursday, the US dollar against the yen saw a slight decline. It is understood that this is the first time that a member of the Bank of Japan's Monetary Policy Committee has made such dovish remarks since the Bank of Japan raised interest rates on July 31.

Since the Bank of Japan raised interest rates on July 31, causing a significant appreciation of the yen and leading to a large-scale unwinding of yen-funded arbitrage trades, the expectations of the Bank of Japan raising interest rates have triggered an unprecedented negative reaction in the global markets on Monday. In the eyes of some investors, the Bank of Japan is seen as the initiator of a "Black Monday" for global stock markets.

After the Deputy Governor of the Bank of Japan unexpectedly made dovish remarks, Asian stock markets turned from a weak downward trend to a sharp rise on Wednesday, rebounding significantly for two consecutive days. The MSCI Asia-Pacific Index surged by as much as 1.8%, and the Japanese stock market continued to surge on Wednesday following a violent rally on Tuesday. The TOPIX index in Japan rose by 4.3% at one point, the Nikkei 225 index rose by over 3% at one point, and eventually nearly recovered from the drastic decline seen on "Black Monday". Benchmark stock indices in South Korea and Taiwan also saw significant gains, with the latter experiencing its largest single-day increase since May 2021 on Wednesday.

The culprit of the "Black Monday" in global stock markets: Forced large-scale unwinding of arbitrage trades

As the recent tightening of monetary policy by the Bank of Japan seemed to trigger a historic plunge in the Japanese stock market and led to market turmoil globally, the central bank is facing significant public pressure.

The TOPIX index experienced two consecutive days of record declines before rebounding on Tuesday, leading to a global stock market crash on Monday, mainly due to the unexpected rise in the US unemployment rate fueling expectations of an economic recession in the United States. The accelerated rise of the yen exchange rate prompted arbitrage trades to unwind rapidly, and investors' concerns about the potential impact of further interest rate hikes by the Bank of Japan on Japan's fragile economic recovery and the yen's appreciation severely affecting major exporters like Toyota, led to a sharp decline in the Japanese stock market on Monday, triggering multiple circuit breakers and causing a global stock market meltdown.

At the same time, the market believes that the Federal Reserve's interest rate cut will be much larger than previously expected. Therefore, the recent rapid appreciation of the yen prompted traders to quickly unwind yen-funded arbitrage positions, which forced some traders to sell a large number of highly liquid stocks such as US technology stocks to offset the huge losses caused by borrowing yen This also led to the entire financial market falling into a vicious cycle of selling off risk assets on Monday. Especially since early July, the 11% rise in the Japanese yen exchange rate has been in line with the 13% decline in the benchmark for US tech stocks - the Nasdaq 100 index.

As the Japanese yen rapidly appreciates, the risk of this arbitrage trade significantly increases. Since they borrowed in Japanese yen, if the yen appreciates, leveraged forex traders must buy back the yen at a higher price to repay the loan. This can result in a significant reduction in their actual returns, and even substantial losses.

At the same time, when the Japanese yen exchange rate appreciates rapidly, traders usually choose to quickly close out their positions to offset potential losses. This means selling off a large amount of liquid assets such as stocks and junk bonds to buy back the yen. Additionally, since the Japanese yen is traditionally considered a safe-haven currency, some traders may sell off risk assets on a larger scale to purchase yen, in order to hedge risks in the global market turmoil.

From a long-term perspective, the trend of Japanese yen appreciation is hard to avoid

Yusuke Miyairi, a forex strategist from Nomura International, stated: "You can still make a considerable amount of arbitrage profit by shorting the Japanese yen against the US dollar, but in the current unstable market, it is clearly not worth it." "We expect that by the end of September, the USD/JPY trend will stabilize around 143."

On Wednesday, Uchida stated that the recent global financial market trends are "extremely unstable," and the Bank of Japan needs to temporarily maintain loose monetary policy. He also emphasized that the Bank of Japan will not hastily raise interest rates in unstable markets, which is a stark contrast to the hawkish policy stance of BOJ Governor Kuroda last week. In subsequent remarks, Uchida pointed out that communication with the market needs to be handled cautiously.

"After the latest speech by the BOJ Deputy Governor, current yen positions are still short, indicating that future trends may depend on the policy actions of the Federal Reserve and the economic conditions in the US," wrote Charu Chanana, forex strategy head at Saxo Markets, in a report. "However, the future risk-reward balance still favors the yen due to expectations of the BOJ tightening monetary policy further strengthening, with the specific timeline possibly depending on the Fed's rate cuts."

For UBS, the decline in the Japanese yen exchange rate on Wednesday may be short-lived, as the bank's strategy team recommends investors to actively buy the yen, as they expect the yen to appreciate by over 10% by the end of 2025.

Analysts from TS Lombard expect that speculative traders in the forex market may need to find up to $1.1 trillion to repay the massive yen loans from arbitrage trades, and stated "it seems unlikely that this wave of arbitrage trade closures will end soon."

Arindam Sandilya, Co-Head of Global FX Strategy at JP Morgan, recently stated that as the Japanese yen remains one of the most undervalued currencies, there is still more room for closing out arbitrage trades. Arindam Sandilya said: "We are not done yet. The closure of arbitrage trades, at least in the speculative investment community, has already completed about 50% to 60%." Arindam Sandilya said that it is unlikely for arbitrage trading to return to the level before the yen's rise in the short term, as the technical damage caused to investment portfolios by large short-term fluctuations is not easy to eliminate. He said, "A good outcome would be for the market to stabilize near current levels, possibly with a slight recovery at most. However, in many cases, we often see the continuation of trends, even if the speed is slower than before."

Bank of Japan Deputy Governor Uchida has long played an important role in the process of normalizing the Bank of Japan's policy direction, so his remarks often represent the stance of the Bank of Japan. In March of this year, the Bank of Japan raised interest rates for the first time in 17 years, ending its ultra-loose policy. Subsequently, in July, they further lowered interest rates, and Bank of Japan Governor Haruhiko Kuroda once again "hawkish" at the press conference after the Bank of Japan's July rate decision, stating that if the price outlook becomes a reality, the Bank of Japan will raise interest rates again, and he indicated that 0.5% is not a specific interest rate ceiling.

Current pricing data in the forward trading market shows that after Uchida unexpectedly made dovish remarks, the likelihood of a 25 basis point rate hike at the Bank of Japan's December monetary policy meeting is only 30%, much lower than the 60% or more the day after the rate hike last week