Short positions in the yen are beginning to unwind! Capital inflows and the closing of carry trades may trigger a "reversal trend."

Just six weeks ago, the exchange rate of the yen against the dollar had just hit a 40-year low. Now, a combination of multiple factors has finally begun to shake the aggressive shorts that had long bet on the yen's depreciation, and the long-declining yen is ushering in a turning point in its fate. Although the Bank of Japan's interest rate hikes and record currency interventions had previously failed to provide lasting support to the yen, new variables such as capital repatriation, unwinding of carry trades, and political pressure from the United States are forcing yen sellers to reconsider their long-term strategies. The market's psychological expectations for the yen appear to be shifting, said Rong Ren Goh, a fixed income portfolio manager at Eastspring Investments. Investors are increasingly reluctant to aggressively short the yen, especially as the prospect of a rate hike by the Bank of Japan in September adds new risks to such trades. The market widely expects the Bank of Japan to raise the benchmark interest rate by 25 basis points this month, but some traders have already begun to price in a 50 basis points hike or a series of rapid hikes in the coming months. However, under the consistently cautious leadership of Governor Kazuo Ueda, a 50 basis points hike in September is still regarded as a very low-probability event. The shift in market sentiment has been corroborated by capital flows. Data from Citigroup shows that since early August, yen positions have shifted from net short to net long; interbank fund flow data also indicates that leveraged funds, banks, and real-money investors have all been net buyers of yen this week. The resonance of central bank policies, capital flows, and speculative positions is intensifying exchange rate volatility. The yen is expected to rise 2.3% against the dollar this week, marking the largest single-week gain since the US-Japan joint intervention at the end of July. Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management, warned that the risk of massive unwinding of yen carry trades is rising, reminiscent of the situation in 1998 when banks and hedge funds were forced to deleverage quickly following the collapse of Long-Term Capital Management (LTCM). When a currency is extremely undervalued and positions are overly crowded, such volatility tends to occur more frequently before a significant move arrives, Jen said. Its like an earthquake tectonic plates are grinding against each other under immense pressure. Intervention and the Federal Reserve: Signs of Policy Coordination The yen's years-long depreciation trend accelerated further this year due to concerns about the fiscal sustainability of Prime Minister Fumio Kishida's stimulus plan, alongside a general belief that the Bank of Japan is behind the curve in terms of monetary tightening. Between April and May, when the yen fell below 160 against the dollar, the Bank of Japan implemented a record-scale unilateral intervention. A key turning point for the yens movement occurred between July and August after the yen fell to 163.99 (its lowest level since 1986), the US unusually teamed up with Japan for a joint intervention. US Treasury Secretary Scott Yoshio has long advocated that interest rate hikes are the correct way to curb yen weakness, and he reiterated pressure on the Bank of Japan during this weeks G20 finance ministers' meeting. Subsequently, Bank of Japan board member Hajime Takata the sole dissenter in the July decision to maintain interest rates gave a speech suggesting the possibility of a 50 basis point hike or more aggressive consecutive hikes. His comments on consecutive rate hikes and larger adjustments are quite impactful, said Yoshio Iguchi, chief strategist at Traders Securities. If this becomes the consensus, it will be a game changer for the yen. According to data from Tokyo Tanshi, market bets on the likelihood of a 25 basis points rate hike by the Bank of Japan to 1.25% in September have risen to 97%, far above the 52% just a month ago. Additionally, the probability of a rate hike in October is at 27%, and in December, it is at 56%. Accelerating Capital Repatriation: Signs of Domestic Institutions "Returning Home" Meanwhile, signs indicate that the sudden rise in Japanese government bond yields to historical highs is prompting domestic institutional investors to pull back funds to their homeland. In July, the Japanese government disclosed that its government pension investment fund (GPIF) of up to $1.8 trillion may shift its asset allocation focus back to domestic investments, a revelation that caused turbulence in global markets. Official data show that Japanese investors are reducing their holdings of foreign bonds at the fastest pace in four years. The direct factor behind the yen's strengthening is the market speculation that the Bank of Japan's interest rate hike might exceed expectations, which clearly has drawn everyone's attention, said Bart Wakabayashi, head of the Tokyo branch of State Street Bank. But looking at it from a broader perspective, the biggest single factor is that Japanese investors prefer to invest in domestic assets, including liquidating overseas assets. Wakabayashi noted that, according to State Street's proprietary data, real-money investors' net short positions on the yen have surged to a five-year high, paving the way for a "return" of positions toward neutral or even overweight. The Federal Reserve is also a key variable. Following dovish comments from Fed Governor Christopher Waller, traders lowered their expectations for an interest rate hike in the US this month, creating space for the Bank of Japan to narrow the US-Japan interest rate spread the main driver of yen weakness. The narrowing of overseas interest rate advantages will also drive the unwinding of carry trades, where investors borrow low-cost yen to invest in higher-yielding overseas assets. A reversal of short positions could trigger significant market movements. JPMorgan estimates that since Fumio Kishida took office in October last year, yen short positions have accumulated to approximately 17 trillion yen (around $108.7 billion). If these positions are completely unwound, the USD/JPY exchange rate could fall to the 142-146 range, wrote JPMorgan analysts Junya Tanase and Ikue Saito in a report.