Global artificial intelligence (AI)-related stocks have been unstable recently.
If investors use the opportunity to unwind yen-funded carry trades, the Bank of Japan's hawkish turn since September could deepen a market pullback.
During Thursday's Asian trading session, the yen rose 0.7% against the US dollar without any obvious major catalyst.
The Nikkei 225 fell 2.7%, and South Korea's Kospi dropped 3.5%.
On the surface, these moves fit the typical pattern of yen-funded carry trade unwinding when market risk aversion rises.
We had previously warned about the link between the latest round of yen-funded carry trades and AI-related stocks.
The prospect that the Bank of Japan may significantly accelerate the pace of rate hikes is adding to market unease.
In September, the Bank of Japan raised rates by 25 basis points, only three months after its previous hike, noticeably shorter than the prior interval of about six months.
Governor Kazuo Ueda announced that the "phase" of monetary policy has changed, signaling further tightening.
Many market participants, including us, expect the next hike in December, continuing a pace of one hike every three months.
This hawkish shift stems from pressure by US Treasury Secretary Bessent, who has demanded that the Bank of Japan raise rates in exchange for coordinated US-Japan currency intervention to support the yen.
We previously pointed out that Bessent's attempt to influence Japanese policymaking could trigger market volatility.
Admittedly, recent inflation trends provide justification for the Bank of Japan's expected rate hike.
The Bank of Japan believes underlying inflation is moving toward its 2% target, with rising oil prices posing an upside risk.
The current policy rate of 1.25% may still be stimulative for the economy, meaning there is still room for further exit from easing.
Even so, we believe that since the last yen-funded carry trade collapse in August 2024, the Bank of Japan may have been too cautious on rate hikes.
US tariff increases, domestic political turmoil in Japan, and the Iran war further reinforced the central bank's cautious stance, causing its pace of policy normalization to lag behind what domestic economic conditions warrant.
We believe this dovish period lasted long enough to foster a new round of yen-funded carry trades.
What we have seen recently may mean these trades are once again facing unwinding pressure.
At a time when the Bank of Japan has suddenly turned hawkish, market expectations about the sustainability of AI-related investment have also become more unstable.
At the same time, concerns about France's political situation and fiscal condition appear to have weighed on global risk appetite, further adding to market pressure.
We maintain our previous expectation that the central bank will raise rates by 25 basis points in December, next March, and July, pushing the policy rate to 2% — likely the terminal rate of this tightening cycle.
But renewed intensification of market turbulence could prompt the central bank to reassess its rate path.
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