Why did the yen surge by 2%? Interest rate hike expectations triggered a wave of carry trade unwinding.

The yen strengthened significantly this week, driven by a wave of carry trade unwinding triggered by hawkish signals from the Bank of Japan.

On Thursday, the yen rose more than 2% against the dollar, hitting a near one-month high and approaching levels seen after Japan's Ministry of Finance intervened in the market in May. The gains continued on Friday.

The immediate trigger for this round of market activity was the hawkish statements made this week by Bank of Japan Governor Kazuo Ueda and board member Hajime Takada, both of whom hinted at the possibility of a significant interest rate hike at the central bank's policy meeting on September 18. The interest rate swap market has already fully priced in the expectation of a 25 basis point rate hike by the Bank of Japan this month, and has also factored in another 75 basis point rate hike by July next year.

As expectations of interest rate hikes rise, carry trades that use low-interest yen to finance the purchase of high-interest assets are facing systemic dismantling pressure. High-interest currencies such as the Brazilian real, South African rand, and Mexican peso all fell by more than 1% against the yen on Thursday, indicating that capital outflows have extended beyond dollar assets.

Bank of America stated that the recent movement of the US dollar against the Japanese yen "reflects a complete reallocation of market risk over the past 48 hours."

The sharp rise in the yen initially sparked speculation of intervention, and hawkish signals triggered large-scale liquidation.

The yen appreciated for two consecutive days on Wednesday and Thursday, with a cumulative increase of nearly 3%, marking its largest two-day gain since August 2024. Wall Street Insights noted that while there were widespread rumors of renewed market intervention by Japanese authorities, data from the Bank of Japan's accounts showed no official intervention behind the rally.

According to Bloomberg analysis, the gap between the Bank of Japan's current account forecasts released on Thursday and estimates from currency brokers is far from sufficient to support the judgment of "large-scale yen buying" intervention.

Bloomberg's analysis of relevant data shows that the Bank of Japan predicts its current account will decrease by 410 billion yen due to fiscal factors, while the average estimate from three currency brokers—Central Tanshi, Ueda Yagi Tanshi, and Tokyo Tanshi Research—is approximately 700 billion yen. The difference is far less than 729 billion yen, representing the smallest intervention by Japan since 2022.

Yuichiro Takai, a researcher at Totan Research, stated:

Based on this data, it is reasonable to conclude that no intervention occurred this time.

The core driver of this round of sharp yen appreciation is the sudden shift in market expectations regarding the Bank of Japan's policy path.

Kazuo Ueda and Hajime Takada's statements this week caught the market off guard. Data from the Chicago Mercantile Exchange showed that on Thursday, the volume of call options on the USD/JPY pair (betting on a stronger yen) was more than 2.5 times that of put options, as many traders took the opportunity to close out their previously accumulated short yen positions.

Sagar Sambrani, a senior foreign exchange options trader at Nomura Securities in London, said:

We are witnessing a large-scale unwinding of yen carry trades, with the market showing significant interest in holding yen compared to other G10 currencies in the medium term. The general consensus seems to be that the era of easy carry trades is over, and the scale of cross-border capital flows from Japan to the United States may have undergone a substantial change.

Masayuki Nakajima, senior strategist at Mizuho Bank in London, pointed out that the driving force behind this round of market activity was the "closing of short positions in the yen – mainly from hedge fund accounts," coupled with strengthened market expectations of further tightening by the Bank of Japan, which together propelled a reshuffling of positions.

Meanwhile, Japanese exporters are accelerating their conversion of dollars into yen, further pushing up the yen's value. Position data shows that short positions in the yen remain substantial, indicating that pressure to close out these positions may persist.

The latest data from the U.S. Commodity Futures Trading Commission (CFTC) for the week ending August 25 shows that leveraged funds held a net short position of 81,619 contracts in the Japanese yen, while asset managers held a net short position of 18,284 contracts. Both types of institutions have begun to reduce their short positions, but the absolute size remains at a high level.

Nomura: Three consecutive interest rate hikes are possible in extreme circumstances

Nomura Securities has given a rather aggressive scenario prediction regarding the Bank of Japan's next course of action.

Yujiro Goto, head of Japanese foreign exchange strategy at Nomura Securities, told Bloomberg TV that a 25-basis-point rate hike this month "seems reasonable," and that consecutive rate hikes in October and December "are not impossible" if the yen's depreciation continues to around 160. This would mean a significant acceleration in the Bank of Japan's pace of rate hikes, which has been roughly twice a year since early 2024.

However, Goto's baseline forecast is relatively mild, believing that there is a high probability that the Bank of Japan will raise interest rates at least once every quarter thereafter, and currently maintains its target price of USD/JPY at 154.

He also pointed out that the government's attitude towards monetary policy will be a key variable in determining whether the yen's rise can be sustained. Investors are closely watching Prime Minister Sanae Takaichi's statements—she has previously expressed reservations about raising interest rates. Goto stated:

If she remains negative about the Bank of Japan raising interest rates, the market will be disappointed, and the yen may be sold off again.

Conversely, if Sanae Takashi avoids making direct statements or emphasizes the central bank's independence, he believes the yen has room to rise further above 150.

Furthermore, the Federal Reserve's actions also pose a potential variable. If the Fed holds rates steady in September, while the Bank of Japan releases hawkish signals at the same time, the USD/JPY exchange rate may fall below 155 earlier than the market expects.

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