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After experiencing "Black Friday" and "Black Monday," the market returned to calm from Tuesday. On Wednesday, the Bank of Japan completely "backed down," with Deputy Governor Uchida Shinichi stating, "We will not raise interest rates when the market is unstable."

The factors that triggered market turmoil began to reverse. The yen fell against the US dollar again, US Treasury yields started to rise, Asian stock markets also began to stabilize, and the renminbi weakened against the US dollar. As of the close on August 7, the US dollar/renminbi was reported at 7.186, and the US dollar/CNH (offshore renminbi) was reported at 7.1911. The renminbi reference rate was reported at 7.1386, depreciating by 68 points. Traders believe that this seems to reflect the People's Bank of China's unwillingness to push for a rapid appreciation of the renminbi.

However, the market may be bidding farewell to the calm and sweet period of the second quarter and entering a more challenging period of volatility— as the yen weakens, the US-Japan interest rate differential expands again, and carry trade may be reestablished; if the Federal Reserve does not act quickly, the US economy may fall into recession; the US general election in the fourth quarter is also highly uncertain at present.

The Bank of Japan's timely statement calmed the market.

On the 7th, the three major US stock indices rebounded slightly overnight, with most star tech stocks closing higher. The Nikkei 225 index, which had just suffered the largest single-day drop in history (-12.4%), set a record for the largest increase ever (+10.23%) on Tuesday. Despite this, global stock markets are still in turmoil, with investors worried about the risk of a US economic recession and the possibility of the Bank of Japan raising interest rates again.

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However, the Bank of Japan's timely statement did indeed give the market a breather. "The deputy governor said on Wednesday that the central bank will not raise interest rates when the market is unstable, which conveyed a clear message to traders—to create volatility to prevent the central bank from raising interest rates again," David Scutt, a senior strategist at JFD Group, told reporters. "This is a surprising statement; the Bank of Japan may be forced by the market to avoid taking measures that would be beneficial to the Japanese economy. This is a significant concession, obviously aimed at restoring calm in the financial markets. Just over a week ago, the Bank of Japan's interest rate hike (15BP) exceeded expectations (10BP) and provided a hard outlook for monetary policy."

The yen weakened rapidly against the US dollar, and as of 17:40 on August 7, Beijing time, the US dollar/yen broke through 147, which had fallen to 141.68 at the beginning of the week, with the yen falling 4% against the US in just two days, and the US dollar index also rebounded quickly above the 103 mark.

The Japanese stock market, which was hit hard by the appreciation of the yen, also returned to calm. The Nikkei 225 index fell nearly 10,000 points from this year's historical high on Monday, and after the rebound on Tuesday and Wednesday, the Nikkei 225 index returned above 35,000 points, with a cumulative rebound of nearly 13% in two days, but it is still far from the historical high of 42,000 points.

The Bank of Japan also stated that it is currently necessary to maintain the degree of monetary easing and hinted that if it does not raise interest rates quickly, the central bank will not fall behind the situation. Most institutions already believe that the Bank of Japan will not continue to raise interest rates within the year.

Morgan Stanley said, "Given that our US economic team does not currently believe that the US will experience a recession, we expect the next Bank of Japan interest rate hike to 0.5% in January 2025, that is, six months later. The January rate hike will depend on the data performance. According to inflation forecasts (assuming yen appreciation), we currently expect the Bank of Japan to maintain a 0.5% policy interest rate. Considering the market turmoil after the release of the US non-farm employment data, if US economic indicators continue to increase the possibility of a recession, Japan may not further raise interest rates at the current 0.25% level."Manulife Investment Management also stated to reporters this week that in this round of the Japanese stock market plunge, the financial sector (including banks, insurance companies, and securities firms) was hit the hardest, followed by trading companies and the automotive industry. Although the financial sector does not have Yen exposure, after the market turmoil, due to the decline in expectations for further interest rate hikes, expectations for the 10-year Treasury yield also changed (the yield expectation dropped from over 1% to below 0.8%), and the market's expectation for the Bank of Japan to raise interest rates by another 25 basis points before the end of 2024 fell from 50% to near 0, which has shifted investors' sentiment towards financial stocks.

Goldman Sachs believes that the Japanese stock market will continue to experience rotation in the future, shifting from large-cap stocks in finance and export-oriented enterprises to domestic demand-oriented small and medium-sized stocks. In other words, the Topix Index may outperform the Nikkei 225 Index. After this 20% decline, the 12-month forward price-to-earnings ratio of the Topix Index has reached 11.6 times, close to the lowest level since 2012. Given the current macro environment, valuations are likely to have been fully adjusted to a level where the fundamentals appear attractive, but institutions remain cautious for the time being. Due to potential further selling and uncertainty about the macro environment such as economic growth and the trend of the Yen exchange rate, the short-term outlook remains unclear.

Scott told reporters: "With the rebound of the Nikkei Index, it has now broken through the key resistance level of 33,700 points, which had limited the rise of the Nikkei 225 Index for most of 2023 before the bullish breakout at the beginning of this year. Going forward, in terms of the upward direction, there are hardly any significant resistance levels to note before 36,985 points."

Carry trade may reignite

It is worth mentioning, has the position of the carry trade been cleared? Or will the carry trade reignite with the weakening of the Yen? These are key issues troubling investors at present.

"The surprising reversal of the Bank of Japan's stance has given traders the green light to rebuild the carry trade until the Bank of Japan signals another interest rate hike or the global economy experiences a significant recession," Scott told reporters.

Currently, the US Dollar/Japanese Yen has broken through the resistance level of 146.5, which means it may test the upward trend of January 2023 again. Traders believe that if the price can stay above 146.5, more US Dollar bulls will continue to buy in, and the next resistance level is near 148.8. Traders believe that if this level is broken, the next upward targets are 149.7, 150.9, and 151.95, respectively.

In fact, currencies that were previously hit hard by the liquidation of carry trades have recently rebounded significantly against the Yen, with the Australian Dollar being the most typical high-yielding currency. On Tuesday this week, the Reserve Bank of Australia stated that it would maintain interest rates unchanged and would not implement a rate cut. Coupled with the continued weakening of the Yen, the Australian Dollar has appreciated by as much as 7.5% against the Yen since last Friday.

Essentially, the current overseas fluctuations began with the US manufacturing PMI falling short of expectations, triggering market concerns about a US economic recession. The non-farm payroll data on Friday evening also fell short of expectations, further strengthening market worries. Although it is actually a relatively long process from data weakening to recession, what can be said at present is that the economy is weakening, but the market itself is wavering between expectations of the economy and interest rates, whether it is the Federal Reserve passively cutting interest rates (the magnitude is less than expected, missing the opportunity for a "soft landing" for the US economy) or actively cutting interest rates (seeking a "soft landing").

Analysts believe that the market should actually release some risks, but the Bank of Japan's strong interest rate hike has directly driven the liquidation of some carry trades. Many previous trades were financed with cheap Yen to invest in high-yielding currency targets such as US Dollar assets, and the reversal of this trade has led to a significant amount of capital returning to Japan to repay debts, causing a certain degree of liquidity dry-up in the short term. On Monday, gold was sold off, and there were not a few hedge funds that needed to exchange for liquidity to cope with the pressure of making up for margin calls.Nowadays, the carry trade has been largely closed, but whether this trade will be re-established in large amounts and have a reverse impact on the market is still worth watching. Morgan Stanley's macro strategy team has stated that the market is beginning to factor in a rapid convergence of policies between the United States and Japan. The question is how much further the yen can strengthen. If the upcoming U.S. data continues to show economic weakness, there is still room for the dissolution of the U.S. dollar/yen carry trade, as the U.S. dollar/yen is still relatively overvalued compared to its fair value based on policy rate differentials. The institution estimates that the current fair value of the U.S. dollar/yen is 137. On Monday, the difference between the fair value and the spot price had narrowed by 60% from its peak level, which can be said that the yen carry trade positions have now been unwound by 50% to 60%.

The future changes in the U.S. economy and the actions of the Federal Reserve are the biggest focus. Scott told reporters that the issue is that if the Federal Reserve does not act quickly, the economy may inevitably fall into a recession, which is also a significant risk for the financial market. The market expects that at the end of August's Jackson Hole central bank annual meeting, Federal Reserve Chairman Powell will give a clearer signal of interest rate cuts. For now, the market has already begun to price in a 50 basis point rate cut in September.