【MACRO Insight】Shifts in Economic Data and Policy Expectations Drive a Dual Recovery of the Japanese Stock Market and Currency

Since 2021, hedge funds have significantly increased their bullish sentiment towards the Japanese yen for the first time, a shift that is a direct response to the violent fluctuations in the foreign exchange market. The yen carry trade, a strategy of borrowing low-cost funds in Japan and seeking high-yield assets overseas, has been thwarted by market turmoil. According to data from the Commodity Futures Trading Commission (CFTC) as of August 13, speculative traders' net bullish view on the yen reflects a significant change in sentiment, from extremely negative at the beginning of July to currently bullish.

Leveraged funds currently hold 86 contracts linked to the appreciation of the yen, valued at about 7 million US dollars. This change in positions occurred after the yen's exchange rate against the US dollar rose about 9% since the beginning of July, the best performance in the G10. Although the Bank of Japan later lowered expectations for interest rate hikes, market volatility has prompted investors to abandon yen carry trades.

In the stock market, the Nikkei 225 index rose sharply by 3.6% on the last trading day of last week, closing at 38,062.67 points, more than 20% higher than the low point on August 5, officially entering a technical bull market. The Topix index also closed up 3%. The yen's renewed softness has driven the Japanese stock market to its largest increase since April 2020, and has led the Asian stock market to its best performance in a year. The robust US economic data, including inflation, unemployment relief applications, and retail sales, has strengthened investors' confidence in the world's largest economy moving towards a “Goldilocks” scenario.

Analyst Hebe Chen pointed out that the Asian stock market has regained a 'perfect balance' feeling, especially the Japanese stock market, which continues to recover strongly with no signs of slowing down. The weakness of the yen may even attract some hedge funds to return to the carry trade that blew up two weeks ago. Hiroshi Namioka, Chief Strategist at T&D Asset Management Co., said that exporters have benefited from the weakness of the yen and the robust US economic data.

The turmoil caused by the recent interest rate hike by the Bank of Japan has created two records: both the inflow and outflow of the Japanese stock market have reached historical highs. In the week ending on August 9, global investors became net buyers of Japanese stocks. Data from the Ministry of Finance of Japan shows that the total amount of shares sold reached 313 trillion yen (about 210 billion US dollars), and the total amount of shares purchased was 319 trillion yen, both setting records for the same period.

Bruce Kirk, Chief Japan Equity Strategist at Goldman Sachs Group, believes that even after the yen carry trade liquidation has brought shock waves to the market, overseas investors' pursuit of Japanese stocks remains strong. He advises investors to take advantage of last week's adjustment to buy, as the recent selling is more technical rather than driven by fundamentals. He also mentioned that there are about 280 Japanese stocks with a daily turnover of more than 20 million US dollars, of which about 50 stocks are very well known to foreigners and have a large position. Kirk also pointed out that as of March, the foreign shareholding ratio of the three largest weighted stocks in the Topix index, Toyota Motor Corporation, Mitsubishi UFJ Financial Group, and Sony Group Corporation, is no less than 20%.

While waiting for Federal Reserve Chairman Jerome Powell to speak on the economic outlook, traders are carefully studying US macro data to judge the timing and speed of the Federal Reserve's interest rate cuts. The upcoming speech by Bank of Japan Governor Haruhiko Kuroda in the Diet may further clarify the interest rate path. These events will have an important impact on the future direction of the yen and the Japanese stock market. In addition, the corporate governance report to be released by the Tokyo Stock Exchange later this month may have an impact on the market.

Some large investors are betting that the Bank of Japan will raise interest rates in the coming months. Vanguard, the world's second-largest asset manager, and M&G Investment Management are among those increasing their short positions in Japanese government bonds, expecting the Bank of Japan to raise interest rates by another 50 basis points before December. At the same time, RBC BlueBay Asset Management continues to sell Japanese 10-year government bonds, and these positions are significantly different from the pricing in the overnight swap market. The overnight swap market shows that there is about a 34% chance that the Bank of Japan will raise the interest rate from 0.25% by the end of the year, down from about 63% at the beginning of this month.

Alliance Bernstein and other institutions believe that unless the yen's exchange rate against the US dollar falls to above 160, the Bank of Japan will find it difficult to raise interest rates further in 2024. However, if these investors' expectations come true, the yen may appreciate further, and Japanese government bond yields will gradually rise. Bank of Japan Governor Haruhiko Kuroda said after the interest rate hike on July 31 that interest rates may continue to rise, but then the market's expectations for more tightening policies have quickly declined. The weak US data, the dovish remarks of Deputy Governor Masayoshi Amamiya, and the changes in the leadership of Japan's ruling party have all cast a shadow over the short-term prospect of raising interest rates.

Mark Dowding, Chief Investment Officer of BlueBay, and Ales Koutny, Head of International Rates at Vanguard, are still looking to increase their bearish bets on Japanese government bonds, expecting the Bank of Japan to raise interest rates again. At the same time, the global financial market is closely watching the policy direction of the Federal Reserve. The US dollar fell to a seven-month low on Monday, while the yen hit a new high for more than a week. The market generally expects Federal Reserve Chairman Jerome Powell to signal the start of interest rate cuts in his speech this week. The FedWatch Tool from CME Group shows that traders believe there is a 23% probability of a 50 basis point rate cut in September, and a 77% probability of a 25 basis point rate cut.

The upcoming release of the July FOMC meeting minutes and the revision of government employment data are expected to affect Powell's remarks and market expectations. Options traders are betting that the US dollar will fall further, expecting Powell to strengthen the reasons for interest rate cuts at the Jackson Hole Central Bank Annual Meeting. Currently, the cost of hedging against a fall in the US dollar is higher than the cost of hedging against a rise in the US dollar, indicating that traders are preparing for a fall in the US dollar.

The emerging market currency index has risen to a record high, reflecting the market's confidence in a soft landing for the US economy. Ulrich Leuchtmann, head of foreign exchange research at Commerzbank, pointed out that the speed of the interest rate cut cycle is the focus of the market's attention. Amundi Asset Management predicts that as the yield gap between Japan and the United States narrows, the yen's exchange rate against the US dollar may reach 140 within the next 12 months. Against this backdrop, hedge funds have turned bullish on the yen for the first time since 2021, with institutions such as First Eagle Investment Management LLC expecting the Bank of Japan to raise interest rates again this year and abandoning hedges on the yen. M&G Investment Management's position in the yen is still high, reflecting the market's expectation of yen appreciation.

In summary, although market expectations for the Bank of Japan to raise interest rates further in the short term have declined, some large investors and asset management companies still bet on the continuation of tightening policies. At the same time, the global financial market is closely watching the policy direction of the Federal Reserve, expecting it to start cutting interest rates in September. Against this backdrop, the trend of the yen exchange rate and Japanese government bond yields will be affected by various factors, and investors need to pay close attention to relevant policy dynamics and changes in market expectations.