The sharp rise of the yen has triggered concerns over arbitrage liquidation, but Morgan Stanley offers reassurance: resilience remains, there is no need to panic!

On Tuesday, the US dollar temporarily fell below the 153 mark against the Japanese yen, reaching a seven-month low of 152.89. Since approaching a 40-year low of nearly 164 at the beginning of last month, the yen has appreciated by about 7%. Market bets on the likelihood of an interest rate hike by the Bank of Japan in September have surged to 98%, combined with massive stop-loss orders triggered after the critical 155 level was breached, amplifying the yen's gains. However, the yen's sharp rise is causing a chain reaction in global financial markets. Investors are concerned that the trillion-dollar carry tradeborrowing cheap yen to invest in high-yield emerging market assetsmay face massive unwinding, potentially triggering a sell-off of emerging market assets. In a report released on September 8, Morgan Stanley's strategy team clearly stated that the yen's strength alone is insufficient to shake the carry trades in emerging markets. Morgan Stanley's core judgment: Volatility is the real "switch," with optimism about the three pillars of carry trades The team led by James Lord, Morgan Stanley's global head of foreign exchange and emerging markets strategy, pointed out in the report that unless further catalysts arise to boost overall market volatility, the likelihood of carry trades in emerging markets being harmed solely due to the yen's strength is relatively low. Morgan Stanley's strategists emphasize that compared to the movement of the yen itself, the global economic growth outlook, global stock market trends, and the fundamentals of major emerging market countries are the key variables influencing the performance of emerging market carry trades. They maintain a positive view on these three factors, believing that "the robust fundamentals of various countries, elevated carry yields, and solid global economic growth momentum continue to keep investors interested in emerging markets." Stock market performance remains a core anchor. The strategists clearly stated: "Global economic growth, global stock market performance, and the bottom-up trends in major emerging markets have a more significant impact on the performance of emerging market carry trades than the movement of the yen. We remain optimistic on this front." Background of yen strength: Rising interest rate expectations and intervention concerns The core driver of this round of yen appreciation is the market's sharply increasing expectations for further interest rate hikes by the Bank of Japan. The interest rate swap market has fully absorbed the expectation of a 25 basis point hike in September, with Nomura Securities even predicting the possibility of three consecutive hikes. The yield on Japan's 10-year government bonds has broken through 3%, reaching a nearly 30-year high, further reinforcing market bets on the normalization of Bank of Japan policy. At the same time, US Treasury Secretary Janet Yellen's public support for a stronger yen has provided additional upward momentum for the yen. In August, the US and Japan implemented their largest coordinated intervention in 15 years, and Yellen's statement kept the market on high alert for further interventions. Evidence of carry trade resilience Morgan Stanley's judgment is not unfoundedthere are actual data to support its views. The divergence in currency performance is a key signal. Since July 29, the Brazilian real has depreciated by 5.1% against the yen, and the Colombian peso has depreciated by 3.4% against the yen. However, during the same period, these two currencies appreciated by 0.7% and 2.4% against the US dollar, respectively. This comparison clearly indicates that the weakening of emerging market currencies against the yen reflects more of the yen's own appreciation rather than a broad sell-off of emerging market assets. The interest rate differential advantage remains solid. Morgan Stanley's strategists pointed out that the US policy interest rate is maintained between 3.50% and 3.75%, while Japan's is around 1%, keeping the interest rate differential advantage for borrowing yen to purchase higher-yielding assets intact. Additionally, the sources of financing for carry trades are no longer concentrated solely in yen. Investors have expanded the range of financing currencies from yen to euros and Swiss francs, reducing the impact of yen movements on overall carry trades compared to the past. Risks remain: Not "out of the woods" Although Morgan Stanley maintains an optimistic outlook on the resilience of carry trades in emerging markets, risks have not completely dissipated. Historical precedents warrant caution. In August 2024, the rapid appreciation of the yen triggered a massive unwinding of carry trades, causing the Topix index to plummet 12% in a single day and the S&P 500 index to drop 3%. If the yen continues to appreciate sharply, the pace of pressure could similarly be swift. Crowded trading areas like AI semiconductors present potential "weak links." During forced sell-offs, funds often prioritize selling their most liquid and profitable positionssuch as AI chip stocks like Nvidia, Broadcom, and Micron, as well as overvalued software stocks like Palantir and Snowflake. Morgan Stanley's strategist team concluded that as long as interest rate differentials and risk appetite remain stable, the strength of the yen alone may not lead to a drastic shift in capital flows. They continue to recommend "buying the dips in emerging markets" and point out that "bottom-up fundamentals, attractive yields, and resilient global growth help maintain investor interest in this asset class." It is worth noting that Morgan Stanley's optimistic assessment is not without conditions. The recent spike in the yen has forced some macro hedge funds and commodity trading advisors (CTAs) to deleverage; if the yen continues to strengthen and further increases global market volatility, the risks of unwinding carry trades may resurface. Morgan Stanley's strategists summarized: "We continue to recommend buying the dips in emerging markets, as bottom-up fundamentals, attractive yields, and resilient global growth help maintain investor interest in this asset class."