The yen carry trade and Japanese interest rates are gaining a lot of attention on Tuesday morning. The governor of the Bank of Japan wrote a letter to the Japanese government, explaining the decision to raise rates in July. He also said that the BoJ will continue to raise interest rates ‘if the economy and prices behave as expected’. The yen is higher on the back of these comments, and USD/JPY is testing the 146.00 level.The yen is the best performing currency in the G10 currency space on Tuesday. Stocks are rising this morning in Europe and US stock index futures are also pointing to a higher open later today. Stocks are gaining along with the dollar on Tuesday.

Why fears about Japan are overblown

The yen story is worth following closely. Some analysts believe that rising Japanese interest rates could be the canary in the coal mine for the current stock market rally and could trigger unexpected volatility. There is some excitement that Japanese investors will trigger a wave of capital flowing from the West back into Japanese capital markets, along with the end of the carry trade. While some repatriation of Japanese capital can be expected, we do not believe this should induce panic or risk aversion. The Japanese respect diversified portfolios, many of their foreign investments may be locked up for some time, and Japan’s demographics mean that investment flows from Japan to Europe and the US will not dry up.

Misjudging US rate cut expectations

Added to this is the fact that the market still does not expect the BOJ to normalize interest rates quickly. Currently, only 9 basis points of tightening have been priced in for December, and 23 basis points for July next year. Even if the market adjusts these expectations upwards, Japan will still have lower interest rates than elsewhere. In addition, there is a chance that the market has mispriced US interest rate expectations. 100 basis points of rate cuts are still expected by the market for December. The interest rate market and the US stock market are telling different stories about the strength of the US economy: the S&P 500 is near record highs, suggesting economic health in the US, while 4 rate cuts in three Fed meetings suggest economic weakness. If this week’s nonfarm payrolls report is stronger than expected, we could see rate cuts being taken out of the market, and a strengthening of the US dollar, which could lead to concerns about Japanese capital flows out of the West being left behind.

UK consumer shows signs of life in August

Elsewhere, the UK consumer is showing signs of life after a mixed performance in recent months. Better weather in August helped like-for-like retail sales grow by 0.8% last month, according to the BRC. This was the biggest monthly increase since March. The 0.8% rise is fairly moderate and is lower than the average monthly increase of 1.3% over the past 2 years. Life is therefore unlikely to get any easier for UK retailers, who will be hoping for a further rebound in the months leading up to Christmas. Next is one of the worst performers in the FTSE 100 so far on Tuesday morning, and we could see more pain for UK retailers as the UK consumer remains lacklustre.

M&A a key driver for UK stocks as Rolls Royce recovers

We continue to believe that M&A activity will be a key driver of UK equity markets in the coming months.after Rightmove became the latest UK-listed company to receive an offer from Murdoch-backed rival REA. Its share price is down 1.9% on Tuesday, and it is currently the worst-performing stock in the UK index. This comes after its share price soared more than 20% on Monday following news of REA’s bid. REA has until the end of the month to finalise its offer. If Rightmove is acquired, it would be a loss for the UK market.

Rolls Royce came under pressure on Monday after Cathay Pacific grounded part of its Airbus fleet due to a faulty part made by Rolls Royce. Its shares fell 8%, however, they are clawing back some losses on Tuesday and RR is currently the second best performing stock in the FTSE 100 and is up around 3.4%. If we see further news suggesting that RR is not to blame, expect a stronger recovery in the share price. Year to date, RR remains the best performing stock on the UK market and is up over 60%.

US Economic Data Watch

The US will be in the spotlight today after the Labor Day holiday on Monday. Nvidia and AI stocks will be closely watched to see if they can continue to recover after last week’s sharp sell-off. The release of the US ISM Manufacturing Index is also expected. It is expected to rise to 47.5 from 46.8 in July. Last month’s report spooked markets about the strength of the US economy, therefore the new orders and employment components will be closely watched.

Focus on volatility

It is worth noting that the markets are reacting at the moment and have not held on to any themes as investors return after the summer break. Therefore, they remain susceptible to volatility. The Vix is ​​currently trading above 15, which is slightly higher than the 1-year average of 14.84. As mentioned above, elevated USD/JPY volatility could also spook the markets. The USD/JPY 1-month options volatility is currently at 12, which is significantly higher than the 12-month average of 9.