Will the yen's strength lead to a resurgence of arbitrage trading unwinding? Will the chaotic situation in August be repeated?

According to the Wisdom Financial APP, an analyst pointed out that with the strengthening of the Japanese Yen, the closure of Yen carry trades may continue in September, leading to a recurrence of the chaotic situation seen in early August. Data shows that since September, the USD/JPY exchange rate has fallen by over 2%. As of the time of writing, the USD/JPY exchange rate stands at 1 USD to 142.93 Japanese Yen.

On one hand, the Bank of Japan recently signaled a continuation of interest rate hikes. Takehiko Harada, a specially appointed professor at the National Graduate Institute for Policy Studies and former governor of the Bank of Japan, stated at a recent event that the Bank of Japan has decided to normalize its monetary policy starting in March 2024. This indicates that the Bank of Japan will very cautiously raise policy rates over the next few years, continuing this gradual normalization process - incrementally raising policy rates towards a neutral level.

Harada mentioned, "The nominal neutral interest rate that the Bank of Japan is trying to gradually approach may be lower than 2%." "Short-term nominal interest rates may be lower than 2%, possibly around 1.5% or even lower." It is worth noting that the Bank of Japan has already raised interest rates twice this year, but has only increased its benchmark rate to 0.25%, still far from the neutral rate level of around 1.5%.

Tsutomu Watanabe, a former Bank of Japan official and economics professor at the University of Tokyo, also recently stated that the pace of interest rate hikes by the Bank of Japan may be faster than expected, with the possibility of two more rate hikes this year. He believes that the Bank of Japan should make greater efforts to communicate these actions to ensure that the market does not panic.

On the other hand, Japanese economic data has also boosted expectations for further interest rate hikes by the Bank of Japan. Data from the Japanese Ministry of Health, Labour and Welfare shows that in July, real wages adjusted for inflation rose by 0.4% year-on-year, marking a consecutive increase for 2 months, mainly driven by spring labor negotiations for wage increases and summer bonuses; during the period, nominal wages increased by 3.6%, marking a continuous increase for 31 months. Additionally, Japan has been experiencing a "rice shortage" in many regions since July, and the rise in rice prices may continue to drive Japanese inflation higher.

Kathy Lien, Managing Director of FX Strategy at BK Asset Management, stated that the closure of Yen carry trades is expected to continue in September, with the risk of another large-scale sell-off. Lien believes that the downward trend in US bond yields and the US dollar will continue to drive the Japanese Yen higher. She said, "Risk aversion has become widespread in the financial markets, which will lead to the continued closure of carry trades that we have already seen." She added that Yen traders will closely monitor equity prices for clues.

Richard Kelly, Global Head of Strategy at TD Securities, previously stated, "If there is indeed a large-scale sell-off in the stock market, we may see more aggressive closure of carry trades, just like in early August." "I believe there are still many carry trades that have not been closed, especially when you look at how undervalued the Yen is. This will change valuations in the next one to two years and have spillover effects."

The Bank of Japan's ultra-loose monetary policy implemented for a long time has significantly devalued the Yen compared to other currencies, making the Yen the most common funding currency globally. However, as the Federal Reserve is about to start a rate-cutting cycle while the Bank of Japan is pushing for policy normalization, the contrasting policy directions of loose US monetary policy and tight Japanese monetary policy have directly driven the surge in the Japanese Yen At the end of July to early August, the rapid appreciation of the Japanese yen dealt a heavy blow to yen-based arbitrage trading. In this type of arbitrage trading, investors often borrow the low-interest Japanese yen (as borrowing yen is almost free with interest rates at historically low levels) and invest in high-yield assets. However, with the rapid appreciation of the yen, many investors who previously engaged in such arbitrage trading are now facing losses from both the decline in high-yield assets (such as US stocks) and the increase in the yen exchange rate (requiring repayment in yen at the end of the trade). This astonishing reversal has triggered a "big unwinding" of global arbitrage trading.

Some analysts point out that the premise of arbitrage trading is the inability to hedge against the exchange rate, so when the yen appreciates, the profits gained from interest rate differentials are quickly eroded by losses caused by exchange rate movements. Closing positions by "selling high-yield assets and buying back yen" will bring further pressure for yen appreciation during the closing process, leading to more yen unwinding, thus creating a vicious cycle.

Some analysts predict that after the easing of the yen's rise in August, the total amount of yen arbitrage trading could reach as high as $4 trillion. Although global stock markets recovered some lost ground after the decline in early August, Kathy Lien warned of the risk of a replay of the financial market turmoil in early August as investors focus on the increasing headwinds facing the stock market and the US economy.

Arif Husain, Managing Director and Chief Investment Officer of Fixed Income at PIMCO, stated that by early 2024, the Japanese yen against the US dollar had fallen to its lowest level since the mid-1980s. However, due to the Federal Reserve's intention to cut interest rates, coupled with the European Central Bank already starting to ease policy, the pressure for the Bank of Japan to raise interest rates may be relatively small. Arif Husain explained that the market turbulence seen in early August has not yet come to an end, and the tightening of policy by the Bank of Japan and its impact on global capital flows could have significant implications in the coming years