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How the yen dethroned the dollar in a single day

The Japanese yen (JPY) rallied to a seventh-month high against the dollar on Monday, as investors turned to the currency as a safe haven against global market risk—in particular in the emerging markets. Investors are buying developed market currencies in an effort to unwind their positions in risky trades during this time of financial turmoil.

The sudden strength in the yen, and the euro as well, is a classic "safe haven" asset rush, but it happened more abruptly than some market pundits expected.

The yen's "rough rise", as it's been called, has placed more market attention on Japanese yen cross currency trades, such as the USD/JPY and EUR/JPY. The USD/JPY pair experienced its largest one day fall since 1998 on Monday, down 4 percent.

Why did the dollar lose steam against the yen?

Market positioning—where investors have already placed their bets—ahead of the sudden correction in stocks provides a partial answer. The market has been short euros and yen and long dollars. There was also a total of roughly $2 trillion invested in emerging markets since the financial crisis—$1 trillion of which has exited the developing economies in a hurry.

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That's one of the reasons that the euro has also rallied against the dollar over the past two weeks. Many analysts believe in addition to the developed markets "safe haven" currency flight, the decline in oil prices has also bolstered European competitiveness and boosted its currency.

The EUR/JPY also raises another dimension in the fast-changing currency trade equation: it's a way for investors to diversify against a weakening dollar, which would be expected if the current market turmoil leads the Federal Reserve to delay an interest rate hike, a move that some prominent economic figures, including former Treasury Secretary Larry Summers, have called on the Fed to consider. Hedge fund guru Ray Dalio of Bridgewater Associates said on Tuesday that he thinks the next Fed move may be more easing, rather than tightening. The dollar was one of the best trades since 2014 as the Fed ended its quantitative easing program and moved closer to its first interest rate hike since the financial crash.

Where the currency kings are today

U.S. dollar/Japanese yen: 119.9450
Prior close: 119.92

Euro/Japanese yen: 137.7800
Prior close: 136.77

U.S. dollar/Euro: 1.14.09
Prior close: 1.1619

For all current currency trade values, go to the CNBC.com currencies data page.

The next currency move

How long this currency shift with the yen and euro gaining on the dollar can be sustained remains open to question. With stocks resurgent on Tuesday after Chinese intervention in its markets with lower interest rates and reserve requirements for banks, the dollar regained its strength from a seven-month low it hit on Monday, and the greenback was ahead of a basket of 10 developed market currencies.

Heng Koon How, a senior FX strategist for private banking and wealth management in Singapore, said it is unlikely that Japanese and euro zone policymakers would be supportive of further rises in the euro and yen, since a stronger currency hurts their export economies. "I would expect verbal intervention to heat up, should euro head higher towards $1.20 [against the dollar] or dollar/yen trades on a sustained basis below 115."

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Not all of the G10 currencies have been gaining strength against the dollar. Currencies in commodities economies including Australian (AUD) and Canadian (CAD) dollars are still being hit hard, said Callum Henderson, global head of foreign exchange strategy at Standard Chartered in a CNBC appearance Monday.

And the euro and yen rally is at this point a short term-position reflecting the risk dynamics in the markets. He noted that the euro in particular has become a favorite in acting like a safe haven when markets sell off and investors exit risk assets, "but its capacity to stay that way remains in question," Henderson said.

On Tuesday, Japan's Financial Minister Aso said that despite the yen's recent rally, the Japanese government had no plans to create a new stimulus package. He stressed that Japan is still on the path to recovery as many Japanese companies have achieved record revenue.

"For the economy to grow stably, it's better for (currency and stock price) moves to be gradual and steady, rather than rough," Aso said.

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"This has happened at time when [economic] data is stalling so I would be surprised if we don't see some form of protest in the trade-weighted appreciation in the euro and yen over the next few weeks if not days, if it continues. But at the moment it is a short term phenomenon," Henderson said.

The emerging markets unwind process that began a year ago isn't likely over. If China continues to slow the investor exit from emerging markets will continue and that will keep pressure on their currencies. And even if the Fed decides to put the brakes on its interest rate hike in the immediate future, the broader global markets context favors all the safe haven currencies: the dollar, euro and yen.

By Krysia Lenzo, special to CNBC.com