The Japanese yen strengthened sharply on Monday, climbing to a seven-month high as traders reassessed the outlook for a currency that has spent much of the year under intense pressure.
The dollar fell 1.14 per cent against the yen to 154.42, its lowest level since February, as investors increased bets that the Bank of Japan (BOJ) could accelerate its interest-rate increases.
The move below the closely watched 155 level has become an important psychological signal for currency traders, particularly after the yen's previous attempts to recover from multi-decade lows were followed by renewed selling.
Analysts said the latest rally is being driven by a combination of factors, including expectations of further BOJ tightening, the unwinding of yen-funded carry trades and the possibility that Japanese investors could begin bringing more money home.
Lee Hardman, senior currency analyst at MUFG, said the break below 155 appeared to have strengthened bullish sentiment towards the Japanese currency.
"So far this year, when we have seen the yen strengthen following bouts of intervention, that 155 level was where dollar/yen tended to bottom out. Breaking past that level is a bullish signal and we could see further upside for the yen," he said.
The speed of the move has caught markets' attention. The dollar was trading above 160 yen as recently as last Tuesday, highlighting the scale of the reversal within a matter of days.
"We could be getting to a tipping point," Hardman said. "The market had seen it as a one-way trade, that the yen would continue to weaken. But we're starting to see the first signs that, with the Bank of Japan picking up the speed of rate hikes, that's starting to have an effect."
Carry trades come under pressure
The yen's renewed strength has significant implications for the global carry trade, in which investors borrow in currencies with relatively low interest rates, such as the yen, and invest the proceeds in higher-yielding assets elsewhere.
For much of the year, the strategy has benefited from the yen's weakness. But a sustained appreciation in the Japanese currency can quickly erode those gains and force investors to unwind positions.
The yen gained more than 2 per cent last week, following a combination of factors that included the unwinding of carry trades and growing expectations that Japanese investors may repatriate funds held overseas.
Eric Robertsen, global head of research and chief strategist at Standard Chartered, said the move represented a potential threat to one of the year's strongest macro trading strategies.
"If the JPY were to strengthen persistently, this may signal that the increase in JPY and USD rates is starting to trigger a change in asset allocation," he said.
He noted that carry trades have remained among the strongest macro performers year-to-date despite higher borrowing costs globally, but warned that the recent appreciation of the yen could challenge that performance.
BOJ rate decision in focus
Markets are increasingly positioning for another BOJ rate increase.
Current pricing indicates roughly a 75 per cent probability that the Japanese central bank will raise rates by a quarter percentage point at its September 18 meeting. Traders are also assigning about a 60 per cent probability to another increase by December.
That shift in expectations is helping to alter the fundamental picture for the yen.
Higher Japanese interest rates would narrow the gap between Japanese and overseas borrowing costs, potentially reducing the incentive for investors to borrow yen and seek higher returns elsewhere.
The euro also weakened sharply against the Japanese currency, falling about 1 per cent to 179.50 yen.
US inflation data could reshape dollar outlook
Despite the yen's dramatic rally, currency traders are also looking ahead to a crucial batch of US economic data.
Friday's US inflation report is expected to be the week's main scheduled market event, with investors watching closely for clues about the Federal Reserve's next interest-rate decision later this month.
Markets are currently pricing roughly a 57 per cent chance of a Federal Reserve rate hike this month, following a stronger-than-expected nonfarm payrolls report.
That makes the inflation data particularly important for the dollar.
"A hot CPI print would all but seal a September hike and underpin a firmer U.S. dollar. A cooler reading would strengthen the case for a hold and leave the U.S. dollar vulnerable to a dovish Fed repricing," said Elias Haddad, global head of markets strategy at BBH.
"Even if a September Fed hike becomes a done deal, we doubt the U.S. dollar will make new cyclical highs. Tightening by other major central banks limits policy divergence."
The European Central Bank is also scheduled to meet on Thursday and is widely expected to raise euro-zone interest rates, another development that could influence relative currency valuations.
The euro was up 0.1 per cent against the dollar at $1.1621, while sterling gained a similar amount to $1.3534.
A possible change in the yen's fortunes
The yen's latest advance represents a striking turnaround for a currency that recently traded at 40-year lows and required coordinated intervention by Washington and Tokyo to stem its decline.
Much of the initial strength generated by that intervention subsequently faded. But the latest rally appears to have broader foundations, with monetary-policy expectations, capital flows and the unwinding of speculative positions all working in the yen's favour.
For investors, the key question is whether the move represents a temporary correction or the beginning of a more durable shift.
A sustained rise in the yen could force investors to reconsider overseas allocations, unwind more carry trades and reduce the pressure that has kept the currency weak.
For now, the break below 155 has given yen bulls a fresh reason for optimism. But with US inflation data and major central-bank decisions due this week, traders may not have to wait long for another test of the currency's newfound momentum.