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In the past month, the Japanese yen has appreciated by 10% against the US dollar. The Bank of Japan's unexpected "hawkish" move has sparked a global storm, with the low-interest-rate yen's carry trade against other high-interest-rate currencies being completely liquidated.

As of 17:30 on August 5, Beijing time, the US dollar/yen was quoted at 141.94, having touched a historic high of 162.01 in July. On August 5, the Nikkei 225 index plummeted by nearly 13%, a rare occurrence in history, with the index's cumulative decline from this year's high already reaching 10,000 points. On the 7th, the yen returned to the vicinity of 145 against the dollar, and the Nikkei 225 index rebounded by 11% at the opening, closing at 34,675 points, up 10%. Currently, the most significant concern for all sectors is how much further the yen can appreciate. This will directly affect the direction of the Japanese stock market and will also influence global market sentiment.

Yen weakens, Japanese stocks rebound

In the short term, technical analysis is the most instructive. Stonex's senior strategist, David Scutt, told reporters, "Continuing the trend from last Friday, the currency pair has now broken through the upward trend established in January 2023 and the horizontal support level of 148.5 set in March this year. On the downside, the next significant support levels include 140.25, followed by the intersection of the upward trend line from 2021 and the important horizontal support level at 137.7. If these two support levels are breached, it means that concerns about a hard landing will significantly increase bets on the Federal Reserve cutting interest rates."

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Fortunately, the yen fell back overnight. As of 15:00 on August 6, Beijing time, the US dollar/yen was quoted at 145.5245, with the yen weakening somewhat after its surge. The Nikkei index once again benefited from the weaker yen, closing at 34,675 points, compared to the previous day's close at 31,458 points.

"We have seen a significant rebound in prices after Monday's plunge, pushing prices back up to the previous support levels (which may now act as resistance levels) of 35,280, 35,700, and the former upward trend line since the beginning of 2023. The Nikkei index may need further appreciation of the US dollar/yen in the short term to break through this area," Scutt said.

Overnight, the US ISM services index unexpectedly rose to 51.1, higher than the expected 46.4 and the previous 46.1. This reduced the market's pricing for a recession, and the new orders and employment in the ISM services sector are also expanding (above 50), with the rate of expansion in payment prices accelerating, which also helped stabilize the US dollar against the yen.

Manulife Investment Management told reporters that in this round of the Japanese stock market crash, the financial sector (including banks, insurance companies, and securities firms) was hit the hardest, followed by trading companies and the automotive industry. Inward-oriented industries and defensive sectors performed relatively better, with retail, healthcare, railway, and telecommunications sectors experiencing smaller declines. Although the financial sector does not have yen exposure, after the market turmoil, due to the market's decreased 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 shifted investors' sentiment towards financial stocks; moreover, the positive impact on inward-oriented companies due to the yen appreciation and the resulting decrease in import prices should help support their stock prices.

The institution believes that the current price-to-earnings ratio of the Japanese stock market is 12 times, which is relatively reasonable. Based on an average US dollar/yen exchange rate of 140, a conservative forecast for earnings to be flat for the next two years, while the US stock market's price-to-earnings ratio is as high as 22 times. At the same time, the Japanese stock market is also supported by dividend yields and corporate buyback commitments, with the total shareholder return for the Japanese stock market expected to exceed 5% in the next two years. Although the unwinding of "yen carry trades" may impact the Japanese stock market, based on past experiences of sharp sell-offs, this market decline may be short-lived and intense. The shift from a deflationary to an inflationary environment in Japan is expected to enable companies with pricing power to continue raising prices, driving a sustained revaluation of the Japanese stock market.

The direction of the US-Japan interest rate differential provides clues.In the future, changes in the yield of U.S. and Japanese government bonds will provide an important reference.

Well before the global stock market and the US dollar/Japanese yen began to decline, the spread had already warned of a possible shift in market direction, with the most critical spread indicator being the spread between the 2-year government bond yields of the United States and Japan. This spread had the strongest correlation with the US dollar/Japanese yen last month. Since May, the spread between the U.S. and Japan has been narrowing, which has been contrary to the persistently strong US dollar/Japanese yen, and may have already signaled an impending turning point.

"Therefore, if this relationship continues, the relative spread between the United States and Japan may provide clues as to when the US dollar/Japanese yen and the Nikkei 225 Index will bottom out," said Scott, adding that so far, there has been no sign that the relative spread has begun to widen again, and it is still necessary to watch whether the yen will strengthen again.

UBS Investment Bank's Chief Japan Economist Masamichi Adachi told reporters, "Last week, the hawkish stance of the Bank of Japan exceeded our expectations, and we expect an interest rate hike to 0.5% in October. After that, we expect the Bank of Japan to remain on hold in December and January next year to ensure that wage negotiations in 2025 achieve high wage growth again in the spring negotiations, and then raise the policy interest rate to 0.75% in March next year, and to 1.0% in June."

Institutional heavy cutting of Japanese yen net short positions

At present, the change in positions of global investors is also crucial. The Commodity Futures Trading Commission (CFTC)'s Commitments of Traders (COT) weekly report provides a net position detail of "non-commercial" (speculative) traders in the U.S. futures market. According to the latest released COT report, the trend of Japanese yen short covering in recent times is quite obvious.

The downward trend of Japanese yen futures has been going on for 12 years. However, the nearly 12% surge in the past 3 weeks has led some speculative institutions to speculate that traders may have seen an important low point for the Japanese yen (or a high point for the US dollar/Japanese yen). The COT report shows that the most impressive rebound of the Japanese yen is that large speculative institutions have pushed their net short exposure to a 17-year high, very close to the historical high. Asset management companies have set a historical high. But as of last Tuesday, they have reduced their net short exposure by about 60%.

The report shows that short covering is the main reason, but bullish bets have been gradually increasing in recent weeks. If the 6% increase in the Japanese yen from last Wednesday to Friday is taken into account, then large speculative institutions are very close to a net long position.

Focus on the Fed's interest rate cut pace and the possibility of recession

In addition to the Bank of Japan, the stance of the Federal Reserve is also crucial, which will directly drive the direction of the US dollar/Japanese yen, a mainstream currency pair. For now, an interest rate cut is almost a foregone conclusion, the question is just how aggressive the cut will be.On August 2nd, the U.S. non-farm payrolls data for July revealed that the unemployment rate unexpectedly rose to 4.3%, a near three-year high, up from the previous 4.1%, marking four consecutive months of increase. This triggered the "Sahm Rule," which has a 100% accuracy rate in predicting recessions. A "recession trade" is brewing, with Goldman Sachs even mentioning that if subsequent employment data continue to fall short of expectations, the Federal Reserve may urgently cut rates by 50 basis points in September. The ISM manufacturing report released on August 1st was weak, with the overall PMI index contracting at the fastest pace in eight months, and employment and new orders contracting even faster. On that day, the yield on the 10-year U.S. Treasury note broke through the 4% mark, and it has now fallen into the 3.6% range.

"It needs to be recognized that, due to the current high interest rate levels, the Federal Reserve has a lot of room for maneuver. The adjusted real interest rate is +250 basis points. The current situation may force the Federal Reserve to cut rates by 50 basis points at the next meeting. The market currently estimates a 67% chance of the first 50 basis point rate cut," said Gary Dugan, CEO of The Global CIO Office, to reporters.

Goldman Sachs still expects the terminal rate to be between 3.25% and 3.5% (currently at 5.25% to 5.5%), and has not changed its forecast of cutting rates by 25 basis points every other meeting in 2025 and 2026, partly because of the belief that economic policy uncertainty will be greater after the elections.

It is not hard to imagine that after a relatively calm second quarter, market volatility may continue for a while before facing the uncertainty brought by the U.S. elections. Last week, traders increased their net long exposure on dollar futures by $6.3 billion. However, due to the weak non-farm employment report, the dollar plummeted by 1% on Friday, as the expectation of an economic recession loomed. But, if we are indeed heading towards (or have already entered) an economic recession, then no matter how many rate cuts the Federal Reserve makes, the dollar will ultimately become a safe haven.