Foreign exchange traders in Tokyo warned of future “extreme volatility” on markets as the US dollar continues its surge against most leading currencies and dealing floors brace for severe ructions in the massive yen carry trade.

The huge exposure of Japanese households to foreign exchange fluctuations — some believe it could be worth as much as $1 trillion (£535 billion) — means that even relatively small shifts in their investments can leave markets reeling.

It was the collapse of the yen carry trade in August 2007 that accentuated the global ripples from the US sub-prime debacle, crushing several large hedge funds and causing havoc for Japanese exporters.

With the yen and Korean won bucking the global trend and rising against the greenback on Thursday, traders described a striking unpredictability in the direction of currencies amid swirling rumours that South Korean central bankers were preparing for a more aggressive round of currency intervention.

Korea is viewed by many Asia economists as the “canary in the mine” in terms of possible policy decisions by other central banks: snared between inflationary pressures and a slowing global economy, interest rate policy is even more delicately balanced than usual, leaving currencies at the mercy of increasingly desperate second-guessing by traders.

The growing sense of unease, particularly among Japan’s army of individual foreign exchange investors, has triggered several highly volatile trading sessions. The fallout follows downbeat economic data as hopes that the global economy might hold up better in the face of a prolonged US slowdown have taken a beating.

Recent data from Japan suggest that the world’s second biggest economy has finally tipped into recession. The Cabinet Office revealed on Wednesday that the economy had shrunk by an annualised 2.4 per cent during the first quarter of the financial year. Worse still, Japan’s terms of trade — the income gained on a given volume of imports and exports — are falling at their fastest pace in 28 years, according to Kyohei Morita, an economist at Barclays Capital.

Korea, which is also forced to import the majority of the raw materials that go into producing its exports, has been similarly hammered.

Amid the turmoil surrounding the dollar’s 10-day surge against most global currencies, focus has swung to the yen-carry trade — the trading bet in which the Japanese currency is borrowed at low rates of interest and used to buy currencies or foreign assets with bigger yields. The trade works well until the yield gains are wiped out by foreign exchange fluctuations, at which point many investors become forced sellers.

With Japan’s households effectively losing money by leaving their savings in the bank, huge quantities of yen — some analysts put the figure at around $45 billion — have been used to buy higher yield currencies such as Australian and New Zealand dollars.

As Japanese retail traders trim their positions and buy back yen, those other currencies have plunged. Analysts believe the sell-off could cause the yen to rise against the dollar, further damaging the bottom lines of Japanese corporations whose earnings profile favours a cheaper yen.

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