Here's What the Yen's Rapid Surge Means for Fed, Stocks, and the World Economy

A lot has happened since I last updated you all about what's happening in markets. Mostly, I think the yen's rapid and sudden rise this month plays a big role in a) unwinding the carry trade, and b) the big dent in risk sentiment (which is being exacerbated by earnings that aren't stellar enough for overzealous traders).

Before we break that down, take a look at this incredible chart from my Bloomberg News colleagues Ruth Carson and Winnie Hsu in their story about how the yen move has spurred `widespread liquidation' across markets.

Carry trades typically reward investors with steady returns over time. A rapid unwind tends to hurt risk sentiment, so the current shift adds to the potential the latest leg lower in tech stocks can extend. The inverse correlation between the yen and tech equities is strong and consistent. A weaker yen has historically been a key pillar for the global carry trade, supporting investments in higher-yielding assets.

Today I also looked at the working assumptions around what such a rapid and sudden surge in the yen -- the world's third most traded currency -- means for global rates.

The yen's move reinforced the global bond yield curve steepening trade as investors bet that the gap between Treasuries and Japanese bonds will narrow. If the BOJ does indeed raise interest rates next week or at least signal its willingness to do so, it’ll also be a strong signal to markets that the Fed will likely cut interest rates in September, an outcome that money markets have now fully priced in.

If the BOJ is indeed comfortable raising interest rates after its lost decade has now been replaced with ongoing inflation pressures, it means that global central banks, including the Fed, might be reassessing their inflation targets and tolerance levels in light of new economic realities with the AI hype, services sector, and resilient consumer spending -- thanks to buy now pay later and interest-free installment services from companies like Klarna and PayPal -- driving that strength.

The Fed’s traditional commitment to a 2% inflation target may be re-evaluated in this context, allowing for higher inflation in the short term to ensure economic stability. Persistent inflation pressures globally suggest that maintaining a strict 2% target is increasingly challenging and also complicates arguments about what the neutral rate of interest is and the calculus of term premia.

While it is true that markets have been far more aggressive in betting on rate reductions or hikes throughout the post-pandemic cycle, concerns about the impact of high interest rates (and the lagged effect) on economic growth is valid. We’re already starting to see that in Germany, where the manufacturing sector bears the brunt of its weakness per the latest PMI reading. It’s as if traders are telling central bankers: Cut interest rates now before your economies need it. It’ll only be a matter of time before that happens.

The strong prospect of Donald Trump winning the US election and his views on the yen and yuan versus the dollar as well as tariffs has also contributed to the unwinding of the carry trade. Not to mention that any big spending plans will likely be inflationary and have implications for monetary policy too.

Some bits from my reading shelf on this theme:

• Masaki Kondo's excellent reporting on the carry trade hanging in the balance.
• John Authers on cracks forming beneath the surface for consumers.
• And former Fed official Bill Dudley calling for a rate cut now.
• Robin Wigglesworth on the yen, with great insights from Deutsche Bank’s George Saravelos on the drivers behind its move.

For Bloomberg subscribers, check out MLIV <GO> for more analysis from myself and colleagues. And for those who are keen to share their views on what happens next in FX, why not weigh in the latest MLIV Pulse survey here? It's anonymous and will only take a few minutes. As the caveats go, any views expressed here are my own and not investment advice.