Yen arbitrage reverses the volatile market, experts predict that rate hikes will intensify volatility and favor Japanese bonds

According to the Zhitong Finance and Economics APP, Puxin fixed income manager Arif Hussain had previously warned of last year's rise in Japanese interest rates, likening it to the "San Andreas Fault of the financial world." Now, his market turbulence risk prediction has been validated. Following the intense reversal of the yen carry trade triggered by the rate hike in Japan in July, Hussain warned investors that they "have just witnessed the first change in this fault, and there will be more in the future."

Hussain pointed out that despite the strong demand for the yen on August 5th due to the firm stance of the Bank of Japan and concerns about the slowdown in the US economy, investors may have overlooked the underlying reasons for the global stock, currency, and bond market downturn. This includes a large amount of overseas investment in Japanese funds, which may flow back domestically as interest rates rise in Japan, the world's fourth-largest economy.

Hussain emphasized that viewing the yen carry trade as a scapegoat overlooks the beginning of a larger trend. He wrote that the Bank of Japan's monetary tightening policy and its impact on global capital flows will have far-reaching effects in the coming years. His company manages around $1.57 trillion in assets.

The sudden halt of the yen carry trade led to the largest drop in the Nikkei 225 index since 1987 and pushed the stock market volatility index VIX higher. Economists had predicted that the Federal Reserve might need to cut interest rates by half a percentage point or take action during the meeting, which is usually a crisis response measure.

It is worth noting that Federal Reserve Chairman Powell stated last month at Jackson Hole that the "time has come" for rate cuts, while the Bank of Japan also hinted at further rate hikes in two research reports, with Governor Kuroda expressing this view in comments to parliament. These developments prompted foreign exchange strategists to reassess the yen's trend.

Christopher Wong, a foreign exchange strategist at Oversea-Chinese Banking Corporation, said that these events have increased their confidence in lowering their year-end target for the US dollar against the yen from 141 to 138. He explained that the Fed's rate cut cycle means that the policy rate differential with the Bank of Japan will narrow.

As one of the institutions bullish on the yen, Macquarie Group Limited lowered its year-end target for the US dollar against the yen from 142 to 135, the lowest level since May 2023.

Standard Chartered Bank expects the US dollar to reach 140 against the yen by the end of this year and drop to 136 in the first quarter of 2025.

Despite the yen fluctuating around 140 against the dollar, market volatility remains high. The expected rate cuts by the Fed and the potential further tightening by the Bank of Japan could once again trigger market turbulence.

With nearly thirty years of investment experience, Hussain tends to increase holdings of Japanese government bonds because he believes that as yields rise, capital may flow back to Japan. He also recommends reducing holdings of US treasuries, citing the potential pressure on US treasuries as Japanese institutional funds flow back Hussein believes that the rise in Japanese bond yields may attract domestic large life insurance and pension fund investors to shift from other high-quality government bonds to Japanese government bonds, which will readjust the global market demand.

Pacific Investment Management Company's Japan branch (Pimco Japan Ltd.) is also preparing to actively invest in Japanese ultra-long-term government bonds, the value of which has been adjusted. Tadashi Kakuchi, the company's Japanese bond portfolio manager, stated that despite the financial market turbulence in August, the Bank of Japan's monetary policy normalization stance remains unchanged, with the earliest "next rate hike expected in January next year."

Since the Bank of Japan implemented quantitative easing in 2013, the forward rate for ultra-long-term bonds has exceeded 3% for the first time. Kakuchi pointed out that the yield curve remains steep, and the timing to purchase longer-term government bonds is ripe. He mentioned that although volatility has recently eased, it "will still be higher than before the Bank of Japan began policy normalization," and for active managers, the presence of volatility is beneficial.

Due to weakening investment demand and the Bank of Japan reducing its purchases of government bonds, the supply-demand balance of ultra-long-term bonds is deteriorating. The Ministry of Finance is also considering shortening the maturity of government bond issuances, expecting increased demand six months later to bring market stability