On Tuesday, the dollar-yen pair briefly broke below the 153 handle during trading, touching a seven-month low of 152.89. Since approaching the 40-year trough of nearly 164 in early last month, the yen has appreciated by approximately 7% in cumulative terms. Market bets on a September rate hike by the Bank of Japan have surged to 98%, and the breach of the critical 155 level triggered a wave of stop-loss orders, collectively amplifying the yen's rally.

However, the sharp yen appreciation is now sending ripples through global financial markets. Investors are worried that the trillion-dollar carry trade, which involves borrowing cheap yen to invest in higher-yielding emerging market assets, could face massive unwinding, thereby sparking a selloff in emerging market assets. In a report released on September 8, Morgan Stanley's strategy team made it clear: yen strength alone is not sufficient to shake emerging market carry trades.

Core Judgment: Volatility is the Real "Switch," and Three Pillars Support the Carry Trade

A team led by James Lord, Morgan Stanley's global head of FX and emerging markets strategy, noted in the report that unless there are further catalysts that push overall market volatility higher, the likelihood of yen strength alone damaging emerging market carry trades is not high. Morgan Stanley strategists emphasized that, compared with the yen's own trajectory, the global economic growth outlook, the direction of global equities, and the individual fundamentals of major emerging market countries are the key variables determining the performance of emerging market carry trades. They maintain a positive view on all three factors, stating that "solid country fundamentals, high carry returns, and solid global growth momentum continue to encourage investors to remain in emerging markets."

Equity market performance remains the core anchor. The strategists wrote explicitly: "Global growth, global equity performance, and bottom-up trends in major emerging markets matter more for EM carry performance than the yen. And we remain optimistic on all three."

Background of Yen Strength: Rate Hike Expectations Intensify and Intervention Concerns Loom

The core driver behind this yen surge is the sharp escalation in market expectations for further interest rate hikes by the Bank of Japan. The interest rate swap market has fully priced in a 25-basis-point rate hike in September, with Nomura Securities even forecasting the possibility of three consecutive hikes. Japan's 10-year government bond yield breaking above 3%, a near 30-year high, has further reinforced bets on the normalization of the BOJ's monetary policy. Meanwhile, U.S. Treasury Secretary Bessent's public support for a stronger yen has provided additional upward momentum for the currency. In August, the U.S. and Japan implemented their largest coordinated intervention in 15 years, and Bessent's remarks have kept the market on high alert for further intervention.

Evidence of Carry Trade Resilience

Morgan Stanley's assessment is not unfounded — there is real data to back it up. The divergence in currency performance is a key signal. Since July 29, the Brazilian real has depreciated 5.1% against the yen, and the Colombian peso has fallen 3.4% against the yen. Yet, over the same period, both currencies have appreciated 0.7% and 2.4% against the U.S. dollar, respectively. This comparison clearly indicates that the weakness of emerging market currencies against the yen reflects the yen's own appreciation more than a broad selloff in emerging market assets.

The interest rate differential advantage remains solid. Morgan Stanley strategists point out that the U.S. policy rate is maintained at 3.50%-3.75%, while Japan's is only around 1%, meaning the spread advantage of borrowing yen to purchase higher-yielding assets still exists. Furthermore, the funding source for carry trades is no longer concentrated in the yen. Investors have expanded their funding currencies from the yen to the euro and the Swiss franc, diminishing the impact of the yen's single-currency movement on overall carry trades compared with the past.

Risks Remain: Not a "Smooth Sailing" Scenario

Despite Morgan Stanley's optimism about the resilience of emerging market carry trades, risks have not fully dissipated. Historical precedents warrant caution. In August 2024, a rapid yen appreciation triggered a massive unwinding of carry trades, with the TOPIX index plunging 12% in a single day and the S&P 500 falling 3%. If the yen continues to appreciate sharply, the speed at which pressure spreads could be equally swift.

Crowded trades in areas such as AI semiconductors are potential "weak links." During forced selling, funds tend to prioritize liquidating their most liquid and most profitable holdings — including AI chip stocks like Nvidia, Broadcom, and Micron, as well as high-valuation software stocks such as Palantir and Snowflake.

The Morgan Stanley strategy team concludes that as long as carry returns and risk appetite remain unchanged, yen strength alone may not necessarily lead to a dramatic shift in capital flows. They continue to advise "buying the dip in emerging markets" and note that "bottom-up fundamentals, attractive returns, and resilient global growth help investors maintain interest in the asset class."

It is worth noting that Morgan Stanley's optimistic stance is not without its preconditions. The recent yen surge has already forced some macro hedge funds and commodity trading advisors (CTAs) to deleverage, and if the yen's continued appreciation further elevates global market volatility, the risk of carry trade unwinding could resurface. Morgan Stanley strategists concluded: "We continue to advise buying the dip in emerging markets as bottom-up fundamentals, attractive returns, and resilient global growth help investors maintain interest in the asset class."