The four scenarios of "Yen Carry Trade" reversal, the worst one is: US stocks fall by 20%, and the Fed cuts interest rates by 75 basis points in September!

The drastic fluctuations in the Japanese yen exchange rate this week undoubtedly caught the market off guard. Such significant volatility has heightened concerns about the future trend of the exchange rate.

In the face of such uncertain market conditions, Citigroup's research department has put forward a deep analysis of yen arbitrage trading in its latest report, suggesting that recent market trends seem to indicate a turning point for yen arbitrage trading. Based on this, Citigroup has proposed four possible trends for the future USD/JPY exchange rate.

Citigroup believes that the current decline in the USD/JPY exchange rate is just the beginning of the end of yen carry trades, and a larger decline may occur in the future, hence the recommendation to long the yen. Drawing from historical lessons, in similar past situations, the USD/JPY exchange rate has experienced a significant drop of 30%-40%, leading to a potential 20% drop in US stocks, a 75 basis point rate cut by the Fed in September, and market expectations for a rate cut by the Bank of Japan rather than a hike.

Four Possible Trends for the USD/JPY Exchange Rate

Citigroup believes that the USD/JPY may have formed a long-term resistance level slightly below 162 yen/dollar last month and has entered a downtrend. In response to this, Citigroup has proposed four possible subsequent reversal patterns.

1) Short-term rise to near 162, but long-term decline, bottoming out at 147 (probability 10%)

The first scenario is that the USD/JPY may continue to rise in the short term but is expected to decline in the long term:

This is close to our base scenario so far. The USD/JPY will bottom out at the 350-day moving average (currently around 147 yen/dollar) and over the next six months or so, yen carry trades will dominate again, bringing the USD/JPY close to the slightly below 162 yen/dollar high touched last month.

In terms of supply and demand, the yen selling pressure caused by announced M&A deals by Japanese companies will combine with long-term USD buying by small and medium-sized enterprises, reigniting speculative yen carry trades.

However, the overall upward pressure on the USD may ease around the end of the year, and the interest rate differential will significantly narrow as the Fed cuts rates. Once the currency pair falls below the 350-day moving average (bottom of the triangle and neckline), it will shift to a true downtrend. In this scenario, the recent risk-averse market environment will more or less stabilize, even if only temporarily, with the Fed's 25 basis point rate cut in September. Then the Bank of Japan will raise rates back to 0.5% in December.

2) Rebound to near 155, then decline again, bottoming out at 147.5 (probability 50%)

The second possibility is that the USD/JPY price fluctuates between two converging trend lines (350-day moving average and 100-day moving average), with yen buying interventions and interest rate differentials being the main factors affecting price movements:

In this pattern, the USD/JPY will also bottom out at the 350-day moving average (currently around 147.5 yen/dollar), which has been an effective support line since last year, and rebound to near the 100-day moving average (currently around 155.5 yen/dollar). So far, the impact of yen buying interventions and interest rate differentials will tug back and forth. After such price patterns repeat two or three times, a triangle with a descending upper end and an ascending lower end will form

Later, when the interest rate spread narrows significantly, possibly around the end of this year, the USD/JPY will fall below the 350-day moving average (lower end and neckline), completing a triangle top formation, similar to the first scenario. However, given the recent market instability, the Fed's rate cut in September will not exceed 50 basis points. If the Fed's rate cut stabilizes the market conditions, the Bank of Japan may raise rates to 0.5% at the December meeting.

3) Short-term struggle near 147, then drop to around 142 (probability 35%)

The third scenario is that the USD/JPY price fluctuates between two converging trend lines (350-day moving average and 142 JPY/USD), but the overall trend is downward:

In this case, the USD/JPY will struggle to recover above the 350-day moving average (currently around 147.5 JPY/USD) for a period of time, and the low point of around 142 JPY/USD recorded earlier this week will become a support level. Any potential rebound in the coming months will be limited to around the 200-day moving average (currently around 151.5 JPY/USD).

Subsequently, when the interest rate spread narrows significantly, the USD/JPY will fall below the neckline (around 142 JPY/USD), possibly completing the formation by the end of this year. The adjustment in the U.S. stock market and other risk assets will be greater, and with the market environment being unstable, the market will question whether the Fed's rate cut in September should be 50 basis points or 75 basis points (but the final rate cut may be 50 basis points). In this scenario, the likelihood of the Bank of Japan raising rates this year is small.

4) Sharp decline to 130, or even lower (probability 5%)

The fourth scenario is an extreme case, triggered only by a severe financial crisis, such as a significant drop in the U.S. stock market, leading to a sharp decline in the USD/JPY and deteriorating market conditions:

If a financial shock occurs, such as the LTCM crisis in 1998, with the U.S. stock market falling by more than 20%, the unwinding of accumulated JPY hedge positions will be concentrated in a short period of time. The Fed's rate cut in September this year will be 75 basis points. In this case, the USD/JPY will be unable to sustainably recover above the 350-day moving average (currently around 147.5 JPY/USD), and may then collapse to last year's low of 130 JPY/USD or below. The market will consider the Bank of Japan cutting rates rather than raising them.

Citigroup: Yen still has significant appreciation potential, recommends long yen

Citigroup pointed out that historical data shows that after severe weakness caused by JPY hedges, there is often a significant rebound:

For example, in 1998 or 2007, the final decline in USD/JPY was 30%-40%.

In addition, we have compared the softening of the yen in the 2020s with the 1980s during the Reaganomics era. At that time, the USD/JPY fell by about 40% between the Plaza Accord in 1985 and the Louvre Accord in 1987 Subsequently, by 1995, it had fallen by about 70% in total.

From the perspective of purchasing power parity, there is still significant downside potential for the USD/JPY exchange rate:

Considering that even based on consumer price-based purchasing power parity (PPP), it is around 105 Japanese yen per US dollar, we believe that even after a 20-yen drop in the past month, there is still significant long-term adjustment space for the USD/JPY exchange rate.

In this sense, Citigroup suggests buying the Japanese yen:

We believe that the current decline in the USD/JPY exchange rate is just the beginning of the unwinding of the yen carry trade. We are now entering a period where it is advisable to go long on the Japanese yen