The rapid surge of the yen sparks concerns over unwinding arbitrage positions, but Morgan Stanley reassures: resilience remains, no need to panic!

According to Zhihui Finance APP, on Tuesday, USD/JPY dropped below the 153 mark during trading, hitting a seven-month low of 152.89. Since approaching a 40-year low near 164 in early last month, the yen has appreciated by about 7%. Market bets on a Bank of Japan rate hike in September have surged to 98%, and the triggering of massive stop-loss orders after the 155 key level was breached has further amplified the yen’s rally. However, this rapid appreciation of the yen is sparking a chain reaction in global financial markets. Investors are concerned that the trillion-dollar carry trades—borrowing cheap yen to invest in high-yielding emerging market assets—may face large-scale unwinding, potentially leading to a sell-off in emerging market assets. Morgan Stanley’s strategy team clearly pointed out in a report on September 8: the yen’s appreciation alone is not enough to shake up emerging market carry trades.

Morgan Stanley’s Core Assessment: Volatility Is the True “Switch”, Bullish on Three Pillars of Carry Trades

The team led by James Lord, Global Head of FX and Emerging Market Strategy at Morgan Stanley, stated in the report that unless there are catalysts leading to a further increase in overall market volatility, the likelihood of carry trades in emerging markets being disrupted by the yen’s appreciation alone is not high.

Morgan Stanley strategists stress that compared to the yen’s own moves, the global economic growth outlook, global stock market trends, and the fundamentals of major emerging market countries are the key variables influencing the performance of emerging market carry trades. They maintain a positive view of these three factors, believing that “solid country fundamentals, above-average carry yields, and robust global economic growth momentum continue to keep investors in emerging markets.”

Stock market performance remains the core anchor. Strategists clearly wrote: “Global economic growth, performance of global equities, and bottom-up trends in major emerging markets have a more significant impact on emerging market carry trade performance than the yen’s movements. We remain optimistic on this.”

Background of the Yen’s Surge: Rate Hike Expectations and Intervention Concerns

The main driving force behind this yen rally is the rapidly rising market expectation for further Bank of Japan rate hikes. The interest rate swap market has fully priced in a 25 basis point hike in September, and Nomura Securities has even forecast the possibility of three consecutive rate hikes. The yield on Japan’s 10-year government bonds has broken above 3%, hitting a nearly 30-year high, further strengthening market bets on BOJ policy normalization.

At the same time, the US Treasury Secretary Wally Adeyemo publicly voiced support for a stronger yen, giving the yen additional upward momentum. In August, the US and Japan jointly carried out the largest coordinated intervention in 15 years, and Adeyemo’s statement has kept the market on high alert for further intervention.

Evidence of Carry Trade Resilience

Morgan Stanley’s assessment is not without basis—actual data supports their view.

Divergence in currency performance is a key signal. Since July 29, the Brazilian real has fallen 5.1% against the yen, and the Colombian peso has depreciated by 3.4% against the yen. However, over the same period, these two currencies rose by 0.7% and 2.4% against the US dollar, respectively. This comparison clearly shows that the weakness of emerging market currencies against the yen reflects more the yen’s own appreciation, rather than a widespread sell-off of emerging market assets.

The carry advantage remains solid. Morgan Stanley strategists point out that with the US policy rate remaining at 3.50% to 3.75% and Japan’s at just about 1%, the yield differential for borrowing yen to purchase higher-yielding assets still exists.

In addition, the funding sources for carry trades are no longer concentrated solely on the yen. Investors have expanded their funding currencies from the yen to the euro and Swiss franc, so the yen’s standalone movement has less impact on overall carry trades than in the past.

Risks Remain: Not “Out of the Woods”

Despite Morgan Stanley’s optimism about the resilience of emerging market carry trades, risks have not completely disappeared.

Historical precedents serve as warnings. In August 2024, a rapid appreciation of the yen once triggered massive unwinding of carry trades, causing the TOPIX to plummet 12% in a single day and the S&P 500 to drop 3%. If the yen continues to rise sharply, the pressure could spread quickly again.

Crowded sectors like AI semiconductors are potential “weak links.” During forced liquidations, funds often first sell their most liquid and highly profitable holdings—including AI chip stocks such as Nvidia, Broadcom, Micron, and high-valued software stocks like Palantir and Snowflake.

The Morgan Stanley strategist team concludes that as long as the yield differential and risk appetite are maintained, a stronger yen alone may not result in a sharp shift in capital flows. They continue to recommend “buying into dips in emerging markets,” stating that “bottom-up fundamentals, attractive returns, and resilient global growth help investors maintain interest in this asset class.”

It is worth noting that Morgan Stanley’s optimistic outlook is not without conditions. The recent yen surge has already forced some macro hedge funds and commodity trading advisors (CTAs) to deleverage. If the yen’s appreciation continues to push market volatility higher, unwind risk for carry trades could make a comeback.

Morgan Stanley strategists sum up: “We continue to recommend buying emerging markets on dips. Bottom-up fundamentals, attractive returns, and resilient global growth help investors maintain interest in this asset class.”