SINGAPORE  - A dramatic rally in the yen is tapping one of the most powerful forces in markets: momentum. And as trend-followers who rode the currency's slide to a 38-year low start to flip their bets, investors of all stripes are rushing to get out of the way.

The yen is up 8% on the dollar in three weeks and the speed of the rally has caught market participants off guard.

Funds and trend-following commodity trading advisers (CTAs), who took short positions in calmer times, face losses or at least a new risk calculus, as the yen has sharply retraced a slide that took it from 140 a dollar in January to 161 in July.

At about 150 to the dollar on Thursday, about half the year's paper-gain for yen shorts is gone and the volatility leaves the position less and less comfortable by the day.

With policy meetings in the U.S. and Japan done, and confirming opposite trajectories for interest rates, analysts and dealers say leveraged players' next move will drive the currency market, and that probably means more gains for the yen.

"It's really the price action that drives dollar/yen," said James Malcolm, macro strategist at UBS.

And with trend-followers all picking up the same signals from the market shift, an already big move can get even bigger - and fast.

"Sub-152, a lot of these triggers begin to come in for CTAs, not just reducing the dollar longs," he said. "But actually starting to turn short dollars in dollar-yen."

Being short the yen, whose short-term yields had been anchored at zero since the start of the century, was the world's juiciest currency trade for years - all the more so while the yen steadily declined and forex volatility was low.

Now the factors underpinning the assumption that the yen would stay both cheap and stable are suddenly shifting. A rising stock market is encouraging more Japanese to bring money back home, and the trade deficit has narrowed.

Japanese investors have withdrawn a net 2.2 trillion yen ($15 billion) from foreign equities so far this year, a larger sum than the net 621.2 billion yen investment flows to foreign bonds, according to official data.

At the same time, within four months the Bank of Japan has hiked rates twice and dismantled a policy of capping yields that had acted as a safety-net for short yen positions by ensuring that its interest rates stayed at rock-bottom.

"We remain convinced that the past two years of yen weakness does not represent a structural shift; the sell-off is cyclical in nature and fully reversible," said Macquarie strategist Gareth Berry, who forecasts dollar/yen at 125 by the end of 2025.

REGIME CHANGE

Speculators have cut their bearish bets against the yen by the most in a month since March 2020. At $8.61 billion, the net short position is 40% below April's near-seven year high, according to data from the U.S. markets regulator.

"Dollar/yen technicals have flipped. With a decidedly more hawkish BOJ, markets are now focused on how much they can hike, not if they will," said Rong Ren Goh, a portfolio manager in the fixed income team at Eastspring Investments.

Goh expects more yen gains, as the market is still short the currency.

To be sure, there are fundamental reasons for the yen to remain weak. Japan's policy rate is some 500 basis points (bps) below the U.S. Fed Funds rate and markets project that even in a year's time the gap will be larger than 300 bps.

But investors who remember the last time yen-carry trades unwound in 1998 dread the kind of pain caused by the yen's rally from 147 to the dollar to 101 within weeks, and are getting out of the way.

Tareck Horchani, head of prime brokerage dealing at Maybank Securities in Singapore, expects hedge funds will avoid 'naked' short yen trades, and bet instead via options on even higher volatility.

Bart Wakabayashi, Tokyo branch manager at State Street, says non-leveraged investors have poured in to yen in recent weeks, with the flow among the most extreme in the past five years, as money managers square underweight yen positions back to neutral.

"What's on everybody's mind is this positioning fallout and how long is it going to last," said Wakabayashi.

"We smashed our way through the 200-day moving average ... so this process has probably now created a different technical regime".

Charts had moved such that the dollar could now face resistance around 150.5 yen and the pair might be in a 145-150 range, he said. ($1=150.2000 yen)

(Reporting by Tom Westbrook; Additional reporting by Vidya Ranganathan and Patturaja Murugaboopathy; Editing by Clarence Fernandez)