The Japanese yen is making a strong comeback! Financial concerns easing and safe-haven flows surging, the yen is set to post its strongest weekly gain since November 2024.

With the market increasingly believing that Japanese Prime Minister Takanashi Wanae will win a majority of seats in the Lower House, it will allow the Japanese government to expand stimulus while maintaining the trust of bond investors in fiscal policy, the yen exchange rate (yen against the US dollar) is heading towards its largest weekly gain since November 2024. The yen against the US dollar has appreciated for four consecutive trading days, with a cumulative increase of about 2.8% so far this week. In addition, with the stock market facing large-scale sell-offs due to AI disruption expectations, as well as increased selling of risk assets such as cryptocurrencies, strong safe-haven demand is also supporting the yen exchange rate. However, with the yen strengthening significantly, some investors are starting to worry about the risk of a large-scale unwinding of the yen carry trade, which could trigger sharp volatility in the stock, bond, and currency markets. Investors interpret Takanashi's decisive victory as reducing political uncertainty and lowering the risk of the worst fiscal outcomes, which helps boost the yen exchange rate and pushes down long-term Japanese government bond yields from the multi-year highs touched last month. Japanese Prime Minister Takanashi Wanae acknowledged concerns about the two-year consumption tax exemption for food at a press conference on Monday, and reiterated plans to avoid financing the measure through the issuance of large amounts of bonds. Yamamoto Take, a trader at Mitsui Sumitomo Trust Bank in New York, said, "After the Liberal Democratic Party's overwhelming victory, concerns about the finances have eased and expectations for a rate hike by the Bank of Japan have increased, driving the trend of a stronger yen." Atsushi Mimura, Japan's top foreign exchange official, said that despite the sharp rise in the yen exchange rate this week, the government remains highly vigilant against foreign exchange fluctuations. The market is concerned that the US and Japanese governments may take joint action to support the yen, which also helps limit the yen's decline. "With the historic victory of Prime Minister Takanashi Wanae leading the Liberal Democratic Party, traders are pricing a rare policy combination in Japan - tax cuts without worsening the deficit, possibly supported by internal funding pools. The risk is that this may involve a large-scale sell-off of foreign exchange reserves - a short-term boost for the yen due to buying, but it will also increase volatility in the foreign exchange market as there is no financial script to reference in terms of how far officials are willing to go," said Michael Ball, a macro strategist at Bloomberg. Earlier on January 23, after reports of the New York Federal Reserve Bank conducting a "rate check," the yen surged, but US Treasury Secretary Scott Bessent later said the US had "absolutely no intention" of intervening in the foreign exchange market, causing the yen to weaken significantly. However, Japanese Finance Minister Katsuyuki Tohyama recently said that she is in close contact with Bessent and that they share a major responsibility for maintaining the stability of the dollar against the yen, raising expectations for US-Japan joint intervention in the yen exchange rate. Expectations for a rate hike by the Bank of Japan have significantly increased recently, which is a key driver behind the yen's appreciation. Several members of the Bank of Japan's Monetary Policy Committee have emphasized that the central bank should "hike rates promptly." Overnight index swaps show that the probability of the Bank of Japan resuming rate hikes in April has increased to 78%. Investors will closely monitor the speech by Takashi Natsuki, a member of the Bank of Japan's Monetary Policy Committee, on Friday, as well as US CPI data, to help assess the prospects for the US-Japan interest rate differential and the yen exchange rate. Global stock markets are facing a "Damocles' sword": yen carry trade The yen carry trade can be seen as a "Damocles' sword" hanging over global risk asset markets such as stocks, cryptocurrencies, and high-yield corporate bonds. This trading strategy is essentially a highly leveraged cross-market financing and risk exposure, which, when fundamental driving conditions change (such as a narrowing of bond yield spreads or yen appreciation), not only quickly becomes ineffective but also magnifies shocks through a series of market feedback mechanisms, impacting the global stock markets that have hit record highs and are still on a bull market trajectory, and may even affect global bond and currency markets. The strategy team at BCA Research, a well-known investment firm on Wall Street, recently released a research report stating that the yen carry trade is a "ticking time bomb in the global financial markets." Against the background of expectations for a rate hike by the Bank of Japan and the possibility of Takanashi Wanae's stimulus policy pushing long-term bond yields higher, this hedge fund strategy, which has been extremely popular among traders for a long time, faces the risk of large-scale unwinding and may trigger severe reverse shocks. For a long time, the Bank of Japan has implemented an ultra-low interest rate environment, making the cost of financing in yen extremely low. As a result, investors borrow yen and invest funds in higher-yielding risk assets (such as the US stock market, Euro-American bonds, emerging market assets, etc.) to earn a "spread." This model of generating returns through low-cost yen financing has been widely adopted during periods of ample global capital and high risk appetite, accumulating massive leveraged trading positions. Over time, these positions have become potential risk points that systematically touch global markets because they depend on the continuous existence of yield spreads and the weak yen assumption. However, once risk assets fall or the yen strengthens, or Japanese bond yields soar, this carry trade will quickly unravel. The rising expectations of a rate hike by the Bank of Japan and the upward movement and volatility of long-term Japanese bond yields caused by fiscal stimulus/supply pressure will weaken the trading foundation of "borrowing yen to buy high-yield assets" and increase the probability of forced deleveraging when risk sentiment deteriorates. Recently, several members of the Bank of Japan's Monetary Policy Committee have emphasized that the central bank should "hike rates promptly," and the market's bet on the Bank of Japan's further rate hikes is rapidly increasing. However, fiscal stimulus in the short term may also allow the carry trade model to continue to operate through the path of "rising risk appetite/weaker yen," so what really triggers a large-scale unwinding is often a combination of an upward revision of rate hike expectations + worsening risk sentiment + stronger yen, rather than focusing too much on a single variable. The team led by Arthur Budaghyan, a veteran strategist on Wall Street at BCA, believes that this carry trade model faces the risk of rapidly collapsing similar to 2008, 2015, and 2020. During those periods, the rapid deterioration of global risk sentiment triggered sudden deleveraging, and investors rushed to buy the safe-haven yen.