U.S. Dollar, USD/JPY: Are Yen Carry Unwind Fears Driving the Global Sell-Off?

U.S. Dollar, USD/JPY Talking Points:

• I looked into the backdrop around the equity sell-off starting this week in the piece published earlier today, noting that I would later take a look at the Yen component of that argument.
• While USD/JPY held support at 155.00 well on Friday following the BoJ’s rate hike, an FOMC rate decision combined with Japanese CPI could be helping to drive a bit of risk aversion, as helped along by the fear that the AI rally may be a bit overdone.
• I’ll be looking into each of these markets during tomorrow’s webinar, and you’re welcome to join: Click here for registration information.

Video

Depending on how the rest of this week goes, we could all be looking at a far different reality from last week. 

To be sure the DeepSeek announcement was already there but it was this weekend when fears began to circulate on social media that China has just developed at LLM at a far lower cost with significantly less capex, to the point that it made efforts in America look like a giant waste of capital. And given the gap-higher in stocks from last week’s ‘Stargate’ announcement, when Masayoshi Son of Softbank pledged a whopping $500 billion from a host of different companies, this highlights a major pressure point for global macro markets.

But there’s more to it than just that…

It was last December 18^th at the FOMC rate decision that stocks started their last notable pullback. At that meeting, the Fed came off as less-dovish than they had for most of the prior year, when they were priming markets for rate cuts that arrived in September. But, as those rate cuts arrived so did higher long-term Treasury rates, pretty much the opposite of what they probably expected. And that was likely being pushed by higher inflation expectations which, again, for a central bank that’s starting a rate cut regime, that’s a large indication that they may have just gotten it wrong.

That sell-off from the December FOMC meeting largely lasted until the Monday before last, when the election gap in the S&P 500 finally was filled and at that point, stocks began to jump-higher. This was further pushed-higher by the release of PPI, which was well-below expectations and then CPI, which was in-line for headline by below expected for Core. The next week then saw another jump, with major moves on the back of the inauguration on Monday (which led to a gap-higher on Tuesday) and then the Stargate announcement last Tuesday afternoon (which led to a gap on Wednesday).

That election gap, by the way, was the first zone of support I had looked at for the 2025 Forecast in Equities, as well as the ‘s1’ zone from my top trade idea for this year. You can access the full forecast from the below link:

Indices

SPX Daily Chart

Collectively, the risk trade in the U.S. had put in a massive push in a rather short period of time, and it was easy to get lost in the shuffle the fact that the FOMC meeting from a month prior had seen the bank sound as hawkish as they had in over a year.

I think this played into the pullback that we saw across U.S. equity indices on Friday and, likely, it’s played into the pullback to start this week.

So, FOMC on Wednesday will obviously be a big deal and the sell-off that we saw in stocks, paradoxically, may help to soften the blow from that, as Powell is unlikely to sound aggressively hawkish if stocks are on their back foot and threatening a larger sell-off, at least in my opinion. But outside of the Fed’s control is the Friday Core PCE data which is expected to edge-higher on a month-over-month basis, to 0.2% from last month’s 0.1%, while year-over-year remains at 2.8%.

Collectively, a less-dovish Powell and a slight bump-higher for inflation could be supportive of the U.S. Dollar, but there’s another notable factor here that could be pulling at stocks, and that’s something that we saw show up last summer.

US Dollar Weekly Chart: Support Test at Prior Resistance

Yen Carry Unwind

The Bank of Japan hiked rates last week to 0.5%. Initially, the move showed a bit of Yen-strength but that couldn’t remain, as USD/JPY defended 155.00 and then bounced, as did EUR/JPY and GBP/JPY.

But the Yen-strength that came into play last summer ultimately turned into being a de-leveraging event across global markets. And, after all, what is the carry trade but an opportunity to build leverage? With ultra low rates in Japan an surging rates elsewhere, hedge funds were largely incentivized to go to Japan, get a loan in low-yielding Yen which wouldn’t be too costly to pay back, and then invest that capital in a higher yield elsewhere.

This is the initial seed for the carry trade, and there’s but one problem to the hedge fund as they’re now long Yen, in essence, and the currency is continuing to show weakness because of rate differentials. Well, that risk can be offset with a long USD/JPY trade, either directly or synthetically, and that further adds to the upper spiral that had shown in USD/JPY trends in 2021-2022 or again from 2022-2023 and, then again from 2024 until the 160.00 level came into play last summer.

That then produces a crowded trade and those types of events can go the other way – very fast – in the right backdrop. That’s what produced a 50% retracement from the highs in Q4 of 2022 and another 23.6% retracement in Q4 of 2023.

Last year’s episode was particularly perilous as the Bank of Japan intervened on the morning of July 11^th, the same morning of a below-expected CPI print. While the USD/JPY pair had finally started to show sustained drive above 160.00, the culmination of fear from lower rates in the U.S. combined with the possibility of even higher rates out of Japan created a spiraling scenario. So those that had loaded up in the long side of USD/JPY, driven along by the carry trade, suddenly had multiple reasons to close the position, leading to an aggressive retracement.

USJDPY AD

By August 5^th, we had the third highest VIX spike in history, around the same time that U.S. equities were setting a low. But, at that point, the Fed had started to lay the groundwork for rate cuts to begin in a month and the Bank of Japan started to sound a bit more cautious around future rate hikes, collectively helping to sooth fears as USD/JPY built-in support around the 140.00 handle.

At that point, I started to highlight bullish potential in the pair with a few notable items. There was a failure from sellers to push through 140.00, in the same week that the Fed was going to kick off a rate cut cycle. There had been a continued case of RSI divergence in September, and along the way, price was building into a falling wedge formation, often approached with aim of bullish reversal.

That finally started to hit around the Q4 open, around the same time that the U.S. Dollar started to reverse, as well. And it was about a month later that headlines were proclaiming the return of the carry trade, even as the Fed had begun a rate cutting cycle.

USD/JPY Daily Chart

USD/JPY and Current Risks

The big problem at this point is that inflation in Japan has continued to move-higher, leaving the Bank of Japan little choice but to hike rates. And it still seems as though the long side of USD/JPY is a crowded trade, especially given the rally that took place in Q4 of last year and which largely remains intact today.

Another round of carry unwind could lead to another de-leveraging event, similar to what we saw in Q3 of last year, as USD/JPY weakness, and Yen-strength, compel long USD/JPY hedges to close positions and as that leverage comes out of the market, some of the prior high-flyers that were benefiting from that cheap capital could similarly come off, such as we’ve seen in NVDA (and, saw in NVDA during last year’s carry unwind episode).

So, depending on how this week goes we could be looking at a far different reality. For me – I’m going to continue to monitor matters via price, and as I said in the videos over the past couple weeks, it’s the 150-151.95 zone in USD/JPY that I’m looking to as indication of larger unwind themes. That was the zone that held the highs in 2022 and 2023, coming back into play as resistance-turned-support in the first half of last year.

On the other side of the matter, and this is the argument that I think is more attractive at this point, given the massive importance of this week’s economic calendar combined with the social media headlines around DeepSeek over the weekend, this could be a big of squaring up ahead of some major risk drivers. If holding long equities with a 5% bounce across indices in a couple of weeks, a bit of profit taking made sense ahead of the Fed, PCE, Japanese CPI and a slew of important corporate earnings reports.

USD/JPY Weekly Chart

--- written by James Stanley, Senior Strategist