An argument that we have made on many occasions is that Japan – and specifically the yen – is the place that has to be watched closely when it comes to any slump in risk assets. This now seems to be playing out. While fears about the US economic slowdown have undoubtedly increased and the Fed has been criticised for delaying rate cuts, we are in little doubt that the primary mechanism through which market turmoil has mushroomed is the yen.

The huge difference between Japan’s static monetary policy, up to the March rate hike, and the massive rate hikes elsewhere, particularly in the US, has created a bubble in yen-funded carry trades. But that bubble has exploded as Japanese rates have risen and those elsewhere have fallen. The yen has appreciated by more than 10% against most G10 currencies since the start of Q3. And it is not just in the currency market where this carry-trading unwinding has been evident.

We suspect that it has pervaded all assets. In short, yen weakness and ultra-low Japanese rates in the past have created the conditions for asset price strength, but this has now evaporated and investors are heading for the exits; as usual, the door is very narrow. An indication of this unwinding comes from futures positions, as reported by the Commodity Futures Trading Commission (CFTC).

At the start of July, the number of short-yen contracts had risen to nearly 200k which is the largest net short since 2007; an ominous sign given that yen-funded carry trades arguably contributed to the ferocity of the asset price slump during the global financial crisis of 2008/09.

The latest CFTC data, for the week ended July 30th shows that these short-yen positions had been trimmed by two-and-a-half times to 73.4k. This represents a substantial unwinding of carry trades and we have to bear in mind that data only covers traders and investors that use the futures market. Add in those that do not, and it seems to us that a bubble has exploded here which has not just lifted the yen dramatically but helped facilitate the slump in asset prices. Of course, this rapid unwinding of carry trades required a spark, such as poor US data but our view is that the yen carry trade unwind is the real facilitator of this collapse.

Why do we think this? The most obvious answer lies in how the yen has traded relative to other currencies. For instance, we have seen euro/dollar and sterling/dollar barely budge in response to recent asset price turmoil and that probably reflects the fact that rate spreads between the US, euro zone and the UK have been reasonably stable in recent years. Of course, the Swiss Franc has risen as well, given its status as a funding currency but, even here, the yen has made huge gains recently that seem indicative of the fact that the yen carry trade is the key. If we think back to early 2020, for instance, when asset prices were in turmoil over Covid, Swiss/yen barely changed, and that was because the pre-Covid period had not seen the same build-up in yen carry trades.

We think it is important to draw out the crucial role that the yen and yen-funded carry trades are playing here. If this continues, as seems likely, asset prices will presumably stay pressured even if some of the concerns that appear to have sparked the rout in risky assets, like US economic frailty, prove misplaced.

In our view, dollar/yen is headed for 130 over the next year, or two and, if that continues to come quickly then asset prices could stay pressurised, including riskier G10 currencies and emerging market currencies. But what happens to other more stable currencies, like euro/dollar or sterling/dollar?

We see little reason for these currencies to move dramatically just because the yen has become hugely volatile. The key could be whether asset price weakness exposes financial market vulnerabilities. For instance, the UK pension sector became very vulnerable when gilts slumped in September 2022 after the mini-budget Hence, the next step here is to see whether any such financial frailties show themselves again.