Dollar extends autumn rally but yen is the currency to watch for stocks

Investors in stocks have another area to focus on: Japanese politics and the yen.

The dollar’s solid autumn rally extended into early Thursday trading, defying the signals about lower interest rates from the Federal Reserve and risks from the U.S. government shutdown, as the greenback continues to benefit from political turmoil in Japan and Europe.

The U.S. dollar index, which tracks the greenback against a basket of six global currencies, was marked 0.3% higher on the session at 99.22, reclaiming levels last seen in late July. The benchmark has risen some 2.8% since its early August nadir and is up just over 1.8% since the start of the month.

A great deal of its gains, however, are tied to weakness in two major currencies in the dollar index, the yen and the euro. They comprise around 71% of the six-currency basket.

The yen has slumped nearly 3% against the greenback this month, falling to 153.05, the lowest since February, following the governing Liberal Democratic Party’s move to name Sanae Takaichi as the country’s next prospective prime minister.

Traders are betting her focus on aggressive fiscal polices, supported by near-zero interest rates and structural overhauls, will add to the nation’s teetering debt pile. Political pressure on the Bank of Japan, meanwhile, will keep government bond yields artificially low, the thinking goes.

In France, the shock resignation of Prime Minister Sébastien Lecornu earlier this week, just hours after he had selected his cabinet, underscored the challenges Europe’s second-largest economy faces in enacting the structural and fiscal changes needed to kick-start growth and tackle the nation’s mounting debt.

The euro has fallen around 1.2% against the dollar this month, and was under pressure again Thursday. Investors are weighing the possibility that France faces snap elections and the increased risk that President Emmanuel Macron will need to resign.

The point to watch here is what happens to the yen, because there is a possibility that it could forcefully turn higher, while the euro is more likely to remain stable or weaken. Near-term moves in the Japanese currency will be closely tracked by both foreign exchange traders and stock market investors.

The yen’s rapid decline, and the extremely low rates on Japanese government bonds, are likely to stoke what is known as the yen carry trade. Simply put, investors borrow cheaply in yen, and put the money to work in higher-yielding assets such as domestic and international stocks.

Japan’s Nikkei 225 has risen more than 11% over the past month and closed at a record high of 48580 points on Thursday. The yen is down 3.8% over that span.

A rapid unwinding of that carry trade, however, can cause havoc in global markets. It happened in the summer of 2024, when the yen appreciated by around 12.5% thanks in part to direct market intervention from the Ministry of Finance.

The S&P 500 fell by around 5% over a three-week period ending in early August. Market volatility soared and yields on Treasury bond whipsawed.

“It’s unwise to stand in front of an onrushing train, so let’s see how this one plays out,” said John Hardy, global head of macro strategy at Saxo Bank. “The key will be to get the first policy signals and measure the level of concern this is likely already generating within the Ministry of Finance and at the Bank of Japan.”

The Ministry of Finance doesn’t disclose the levels at which it intervenes, but markets have paired previous surges in the currency to levels between 157 and 161 yen to the dollar.

For the dollar, near-term gains are likely to be tested by the dovish tone established in minutes of the Fed’s September policy meeting, which were published on Wednesday. The length of the government shutdown is a secondary factor.

“The Fed remains reasonably upbeat on U.S. growth prospects, but just doesn’t want to take any unnecessary risks with higher unemployment,” said ING’s global head of markets Chris Turner. “Of course, we’ll have to see how the U.S. jobs data has been faring over the last four to six weeks once the government shutdown ends.”

Write to Martin Baccardax at martin.baccardax@barrons.com