This was the week the worm turned. Since May the yen had hit 16 separate all-time lows against the euro, slumping to a 21-year low in real effective terms, as perceptions that Japanese interest rates will stay extremely low for a long time to come led carry trade investors to borrow yen and seek higher returns elsewhere.
The dollar had also been weak as traders eyed the peak in US interest rates, while higher-yielding currencies that were the beneficiaries of yen-funded carry trades, such as sterling and the dollars of Australia and New Zealand, soared.
But all that changed this week. Short-term speculators who had built up record short positions in the yen, and substantial shorts in the dollar, scrambled to close their positions, selling higher-yielding currencies in the process.
As a result the yen surged 1.4 per cent to a one-month high of Y148.18 to the euro, 2.2 per cent to Y218.11 against sterling, 1.8 per cent to Y88.12 against the Australian dollar, 2.9 per cent to Y74.43 to the New Zealand dollar and 0.1 per cent to Y116.96 to the US dollar.
The greenback in turn firmed 1.4 per cent to $1.2670 against the euro, 2.1 per cent to $1.8652 against sterling and 1.7 per cent to $0.7536 against the Australian dollar, touching highs unseen since July against all three.
The initial catalyst was the release of strong Japanese capital expenditure data, which broke a run of weak numbers and suggested Japanese rates may yet rise above their current meagre 0.25 per cent by the year-end. This was augmented by a view that short-yen positions had simply gone too far.
However the reversal set in in earnest on Thursday when Thomas Mirow, the German deputy finance minister, said yen weakness would be on the agenda at next weekend’s meeting of G7 finance ministers.
Traders had long expected that the perceived weakness of the Chinese renminbi, and other emerging market currencies that are kept low by Machiavellian means, would be on the G7 agenda.
However Mr Mirow’s words, which followed a suggestion from Christine Lagarde, the French trade minister, that the euro’s rise against the yen was a “worry”, indicated that yen weakness was now being viewed just as seriously.
Japanese policymakers scrambled to argue that the G7 has much bigger fish to fry than the yen. But this cut little ice with traders, as did the view of most analysts that the G7 was, in any case, powerless to do anything about the yen.
“What are officials prepared to do about it? The main source of the yen’s weakness is its low interest rates. Does the G7 really want the world’s second largest economy to raise rates more aggressively?” asked Marc Chandler at Brown Brothers Harriman.
Derek Halpenny at Bank of Tokyo-Mitsubishi UFJ added: “We strongly doubt that the subject of yen weakness will get any real attention. How can this group question yen weakness given that the yen has been untouched by Japanese authorities since March 2004? Bar a call for faster monetary tightening, there is very little the G7 can do .”
Similarly, few saw the dollar’s rise as the start of a meaningful rally. Jens Nordvig at Goldman Sachs was typical, foreseeing “significant dollar weakness” over the next three months as US economic growth lags behind that elsewhere and interest rate differentials turn against the US.
Sterling was notably weak as political uncertainty, combined with suggestions that Middle Eastern investors were pumping less money into the UK as oil prices came off the boil, added to the carry trade unwinding.
The New Zealand dollar was talked lower still on Friday as Michael Cullen, the finance minister, reminded speculators of the pitfalls of investing in a currency backed by a current account deficit of 9 per cent of GDP.
A pick-up in risk aversion undermined other higher risk currencies, with the Icelandic krona falling 3.6 per cent over the week to IKr71.47 to the dollar, and the South African rand 1.9 per cent to R7.35 to the greenback.