Yen Carry Trade, US Recession Fears & Japanese Stock Markets

5 min read

Dear Reader,

Welcome back to our latest edition of Market Insights with Sanjeev Kaushik.

In this edition, we delve into the complexities of the global financial landscape, with a particular focus on the Japanese Yen and its impact on broader markets.

We will dissect the intricacies of the Yen carry trade, examining its role in recent market volatility while also briefly assessing the recession likelihood in the US.

Additionally, we will explore the evolving dynamics of Japan’s equity market, providing insights into potential investment opportunities.

So let’s dive right into it..

Today at a glance:

• Understanding the Yen Carry Trade
• Japan’s Market: A Complex Landscape
• The Future of Yen
• The Unspoken Rules of Trading

Understanding the Yen Carry Trade

The recent surge in the Yen, leading to heightened market volatility, has cast a spotlight on the Yen carry trade and its potential impact on central bank policies. This edition dives into this situation, analyzing the remaining unwind potential and the broader financial market implications.

The Yen and Tech: A Complex Relationship

The unusually tight correlation observed between the sell-off in the Nasdaq and the weakening of USD/JPY in recent weeks raised concerns about a leveraged scenario where investors used cheap Yen borrowing to fund US tech stock purchases.

The sell-offs in the Nasdaq and USD/JPY exhibited an unusually tight correlation last month

A more plausible explanation lies in the convergence of multiple factors. The tech sector was already facing challenges due to overvaluation concerns and profit warnings. At the same time, the Yen was supported by a combination of factors including a weaker US dollar, declining Japanese bond yields, and a shift in market sentiment towards safe-haven assets.

While the exact relationship between the Yen and tech stocks remains a subject of debate, it is clear that the two asset classes are interconnected within the complex web of global finance. Understanding this relationship is crucial for investors seeking to navigate the complexities of the modern market.

Yen Carry Trade: Threat to Central Bank Policies?

While the leverage from the Yen carry trade may be lower than feared, it could still lead to larger capital flows compared to usual, potentially tightening financial conditions in Japan.

This could complicate the Bank of Japan’s (BoJ) ability to continue raising rates as planned to combat inflation. On the other hand, it would not necessarily hinder the Federal Reserve’s plans for potential rate cuts.

Deputy Governor Uchida’s recent comments suggest the BoJ’s willingness to adjust its policies to address market volatility and prevent rapid Yen appreciation from hindering progress towards their inflation goals.

Yen Carry Unwind: More Turbulence Ahead?

While the initial shockwaves of the Yen carry trade unwind have subsided, the potential for further turbulence remains a significant concern. Goldman Sachs’ cautious stance on the Yen highlights the ongoing risks associated with this complex investment strategy.

Data suggest that roughly 90% of the carry trade unwind has already occurred.

The increasing likelihood of a US recession, now at 25% according to Goldman Sachs economists, is elevating the Yen’s status as a portfolio hedge. As investors seek to protect their portfolios from economic downturns, demand for the Yen is likely to increase, further amplifying its appreciation. This dynamic could exert additional pressure on the carry trade, forcing more investors to unwind their positions.

Given the uncertain outlook for the Yen and the broader global economy, a cautious approach is warranted. While the carry trade may have offered attractive returns in the past, the current environment suggests a reassessment of investment strategies.

• Diversification: Spreading investments across multiple currencies and asset classes can help mitigate risks associated with Yen volatility.
• Hedging: Employing hedging strategies to protect against adverse currency movements can be beneficial.
• Tactical Opportunities: While the Yen’s strength may present challenges, it can also create opportunities in other currency pairs. Shorting the Euro against the US Dollar could be a potential strategy to consider.

Japan’s Market: A Complex Landscape

Japan’s equity market is undergoing a transformation. Recent volatility, driven partly by the unwinding Yen carry trade, has created a complex investment environment. However, opportunities exist for those who can navigate the shifting landscape.

Key takeaways from the current market outlook:

• EPS Growth: Despite recent challenges, Japan’s corporate earnings are projected to grow steadily over the next three years.
• Valuation Reset: The market correction has led to more attractive valuations, with the potential for a rebound.
• Investor Shift: A potential shift from foreign to domestic investors could benefit domestic-focused stocks and smaller companies.
• Sector Outlook: The report recommends overweighting defensive sectors like Foods and underweighting cyclical sectors like Automobiles and Transportation Equipment.

The Future of Yen

Goldman Sachs maintains a cautiously optimistic outlook for the USD/JPY currency pair. While the recent sharp appreciation of the Yen has been notable, the investment bank believes that the currency’s strength is largely due to the unwinding of the Yen carry trade and increased safe-haven demand amid recession fears.

USD/JPY is once again trading more closely with fundamentals.

The relationship between USD/JPY and US interest rates is likely to strengthen, with a potential upside for the pair if the US economy performs as expected. However, a potential US recession could lead to a significant decline in USD/JPY.

The Bank of Japan’s policy stance is also a key factor. While the BoJ has shown willingness to address market volatility, Goldman Sachs expects the Fed to be more reactive to economic challenges, potentially supporting the US dollar.

Overall, we recommend a cautious approach to the Yen, favoring tactical opportunities in other currency pairs while monitoring the evolving economic landscape.

The Unspoken Rules of Trading

In this video, we reveal four trading truths we wish we had known earlie

Discovering these insights later in our trading journey significantly improved both our profitability and peace of mind.

By sharing these lessons, we aim to help others avoid common pitfalls and enhance their trading strategies. These valuable truths, learned through experience, offer practical wisdom for traders at any stage.