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Japanese stocks and foreign exchange staged a "seesaw" market. As the yen rose rapidly, Japanese stocks suffered severe blows, causing market concerns.

Yesterday, the Topix Index recorded its largest single-day drop since April 2020. Today, Japanese stocks continued to fall sharply, with the Nikkei 225 and Topix Index both falling by about 5%. On the one hand, the sharp appreciation of the yen has had an impact on export companies, while the Bank of Japan's interest rate hike has also dragged down real estate stocks.

The Bank of Japan's "stable yen" measures have led to weaker stock markets, which has put policymakers in a dilemma: should they continue to raise interest rates to strengthen the yen and curb inflation, or maintain loose policies to support economic growth and stocks?

Tetsuo Seshimo, portfolio manager at Saison Asset Management, noted:

The Bank of Japan's interest rate hike has raised two concerns. One is that the stronger yen will have an adverse impact on export companies. The other is whether the economy can withstand it, as there are still many unknown factors.

Bank of Japan Governor Kazuo Ueda's speech at a press conference on Wednesday further reinforced market expectations that interest rates will continue to rise. Tomoichiro Kubota, senior market analyst at Matsui Securities, said:

Governor Ueda was completely different from his previous press conference on Wednesday, with a very hawkish attitude. The market's previous assumption that "Japanese interest rates will not rise and the yen will not appreciate" has changed.

Is carry trading a "structural shift" or a "tactical adjustment"?

Another major focus of the market is whether the recent unwinding of yen carry trades is a structural shift (i.e. large-scale carry unwinding) or just a tactical adjustment (if the stock market falls sharply, the Bank of Japan will be forced to abandon rate hikes).

Bloomberg analyst Simon White pointed out that Japan remains one of the most underestimated global macro risks. Japan's overseas assets are huge, forming a huge structural short position in the yen, which may drive a sharp appreciation of the yen. This will not only put downward pressure on global assets, but also disrupt the Japanese economy, ultimately leading to a reversal of monetary policy tightening and triggering a long-term inflation threat.

There are three main ways that short yen positions could be unwound, each of which could trigger a self-reinforcing surge in the yen:

1. Capital repatriation: Japan has built up a large overseas asset position;

2. Exchange rate hedging: Japan’s overseas investment positions are insufficiently hedged;

3. Carry trade closing: As the yen appreciates and yields rise, carry trade profit margins narrow and are closed.

Among them, the liquidation of carry trades is the most direct factor driving the short-term strength of the yen and the weakness of Japanese/global stock markets.As the yen appreciates, some losses in the exchange rate may exceed the interest rate differential gains, prompting more carry traders to exit, further pushing up the yen.

However, the actual interest rate differential between the US dollar and the Japanese yen is still at an extremely wide level, and carry trades are still very attractive. In addition, the Japanese yen is still the best financing currency option among G10 currencies, and interest rates in other countries are relatively high.

In addition, it is worth mentioning thatJapanese stocks may be supported by the Government Pension Fund's (GPIF) re-increasing its domestic asset allocation. In 2020, GPIF raised its target allocation of foreign assets from 40% to 50%, and this decision may be adjusted at the next review. Considering that the size of GPIF exceeds 1.5 trillion US dollars, a 10% adjustment would mean a purchase demand of up to 22.5 trillion yen.