As the AI-fueled rally in U.S. stocks continues, a hidden chain of risks is forming: the depreciation of the Japanese yen is fueling carry trades, and low market volatility could amplify the impact of any future shock.
The yen's persistent weakness is drawing attention to potential intervention by Japanese authorities. While intervention itself may not necessarily cause sharp market swings, Michael Kramer, founder of Mott Capital Management, notes that the current environment featuring the USD/JPY exchange rate, low volatility, and carry trades driven by AI investments shares similarities with the conditions preceding the U.S. stock market correction in 2024.
Kramer points out that the USD/JPY rate has risen significantly in recent years. In December 2020, it was around 100; it is now approaching 162. A weaker yen increases import costs and exacerbates inflationary pressures domestically in Japan, which is why the government typically aims for currency stability.
The reason investors should monitor the yen's movement, according to Kramer, is its connection to the current AI investment boom, with the key link being the "carry trade."
A carry trade typically involves investors borrowing a low-interest-rate currency, such as the yen, converting it to U.S. dollars to invest in American assets. If investors do not hedge their currency exposure, they can profit from both the dollar's appreciation and the rise in assets like stocks.
Kramer states that such capital flows have contributed to the rise of some risk assets. However, a sudden appreciation of the yen could force the unwinding of these carry trades, putting pressure on markets.
Kramer recalls that a similar scenario unfolded in the summer of 2024. In mid-July that year, USD/JPY rose to around 162, after which the Japanese government intervened by selling dollars and buying yen. Concurrently, weak U.S. CPI data was released, further pushing the dollar lower. Subsequently, the Bank of Japan unexpectedly raised interest rates and signaled a hawkish stance. Days later, soft U.S. employment data provided additional momentum for yen strength.
Within roughly two weeks, USD/JPY fell from 162 to about 144, representing a sharp rally in the yen. Kramer notes that this shift quickly impacted global markets, with the Nasdaq 100 Index falling nearly 15% over the same period.
He believes the U.S. stock market was vulnerable at that time because the rally was heavily reliant on a handful of large-cap tech stocks. Simultaneously, the VIX Index was at extremely low levels, indicating a lack of investor preparedness for potential volatility. Furthermore, implied correlation metrics—which gauge expectations for stock-index co-movement—showed the market was not adequately pricing in the risk of stocks falling in tandem with the index.
Similar signals are emerging in the current market. Kramer observes that USD/JPY is once again hovering near 162, while the three-month implied correlation index is even lower than it was during the same period in 2024.
He specifically highlights that the low point for the 2024 implied correlation index occurred on July 3, with the USD/JPY peak appearing around a similar time. A comparable pattern is repeating this year: the three-month implied correlation index hit a low on July 10, while USD/JPY reached a peak on July 8.
In Kramer's view, the two episodes are not only close in numerical terms but also highly similar in their timing cycles, both occurring in the summer and roughly two years apart. However, he also stresses that markets will not necessarily replay the 2024 scenario simply because similar indicators are present.
Short-term intervention by Japanese authorities on the yen may not immediately trigger a significant U.S. stock market correction. Kramer notes that the 2024 market volatility resulted from a confluence of multiple factors, including a shift in Bank of Japan policy, weakening U.S. economic data, and previously elevated market valuations.
He states that for the yen to sustain appreciation and trigger a large-scale unwinding of carry trades, a more fundamental shift is required. For instance, a surprise interest rate hike by the Bank of Japan could be a significant factor, and signals of Japanese government fiscal spending cuts could also impact markets. Concurrently, a marked deterioration in the U.S. economic outlook, fueling expectations for Federal Reserve rate cuts, could also weaken the dollar and alter the USD/JPY trajectory.
Kramer also cautions that a U.S. stock market correction does not necessarily have to originate from yen-related factors. When a market rally is concentrated in a few stocks with high valuations, triggers for a risk-asset pullback could include corporate earnings disappointments or economic data that reignites concerns about interest rate hikes.
Kramer acknowledges the existence of yen-related risks but notes that a single currency intervention is typically a short-term measure that does not alter long-term trends.
In his view, more attention should be paid to potential changes in how Japanese capital is allocated. If Japan adjusts the investment strategy for its pension funds or alters arrangements for repatriating overseas investment income, the effects could be more enduring. Such structural changes could influence global capital flows and have longer-term impacts on the dollar, yen, and risk asset markets.
On Monday, a Reuters report cited sources indicating that Japan's Government Pension Investment Fund (GPIF) currently has no plans to adjust its target asset allocation but may utilize existing flexibility to direct more funds toward domestic assets. Analysts generally believe that implementing such policy changes faces multiple constraints, making large-scale portfolio shifts in the near term unlikely.
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