Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management, said the risk of a rapid unwind of yen-based carry trades is rising similar to what was seen in 1998 when the collapse of Long-Term Capital Management forced banks and hedge funds to rapidly deleverage.
"When a currency is so extremely undervalued, and positioning is so extended, movements like this one will occur increasingly frequently before a big move," Jen said. "It's a bit like earthquakes. The tectonic plates are grating on each other with great forces."
The yen's years-long weakening trend accelerated this year as fiscal concerns mounted around stimulus plans by Japanese Prime Minister Sanae Takaichi and a strong belief that the BOJ was "behind the curve" in tightening monetary policy.
Tokyo unleashed record solo intervention in April-May when the yen weakened beyond the 160 per dollar line.
But a key moment for the currency came in July-August when Tokyo was joined by Washington in a rare bout of coordinated action after the currency weakened to 163.99, a level not seen since 1986.
U.S. Treasury Secretary Scott Bessent has long believed rate hikes were the right medicine for the weak yen, and he pressed the BOJ during a meeting of Group of 20 finance chiefs this week. That was followed by a speech by BOJ board member Hajime Takata, the sole dissenter to a July decision to keep rates steady, who raised the specter of 50 bps moves or hikes in quicker succession.
"His remarks about consecutive rate hikes and sharper margins were dramatic," Yoshio Iguchi, chief strategy officer at Traders Securities, said about Takata. "If this becomes consensus, it could be a game changer for the yen."
Odds are now 97% that the BOJ will raise its key rate by 25 basis points (bps) to 1.25% according to Tokyo Tanshi data, up from 52% a month ago. The figures show a 27% chance of a rate increase in October and 56% odds in December.
Meanwhile, there are signs a sudden lurch higher in Japanese government bond yields to historic levels is compelling domestic institutional investors to repatriate money.
Global markets shuddered in July when Japan floated the possibility of a pivot by its $1.8 trillion Government Pension Investment Fund back into domestic assets. Official data shows Japanese investors are shedding foreign bonds at the fastest pace in four years.
"The immediate story behind the yen's gain is the suggestion that the BOJ could raise more than expected, and that seemed to catch everybody's attention," said Bart Wakabayashi, branch manager at State Street in Tokyo.
"But if you take it a step back further, the biggest single factor is the possibility that Japanese investors are more inclined to invest domestically, including liquidating overseas assets."
Real money short underweight positions on the yen are at the highest in five years according to State Street's proprietary data, Wakabayashi said, setting the scene for a potential "reversion" to neutral or overweight levels.
The Federal Reserve is another component. Traders trimmed expectations for a U.S. rate increase this month after dovish comments by Fed governor Christopher Waller, giving the BOJ a chance to narrow a rate gap that has been a major factor in yen weakness.
The shrinking advantage of overseas rates will also act to unwind the carry trade, where investors borrow cheap yen to invest elsewhere.
TLT•
