Global Market: Yen carry trade under pressure as currency surge raises unwind fears

Japan’s yen has climbed to a seven-month high, prompting investors to reassess the future of the yen carry trade, a strategy that has played a significant role in global financial markets for years.

The trade is coming under pressure as expectations build that the Bank of Japan could accelerate interest-rate hikes, potentially as soon as its policy meeting next week. Reuters reported that the combination of a stronger yen and expectations of tighter monetary policy is raising questions over whether the long-running strategy is approaching a turning point.

Read more: Global Market: Japan bond yields ease as yen strength tempers BOJ tightening bets

How does the yen carry trade work?

The yen carry trade involves borrowing Japanese currency at relatively low interest rates and using the funds to invest in higher-yielding assets elsewhere. Investors can convert the borrowed yen into currencies such as the U.S. dollar, Mexican peso or New Zealand dollar and invest in bonds or other assets offering higher returns.

When the trade is unwound, investors convert their proceeds back into yen and repay the original borrowing. The strategy generates returns primarily from the interest-rate differential between Japan and the destination market, while movements in exchange rates can either boost or erode those gains.

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According to Reuters, annualised returns on dollar-yen carry trades are currently around 2.5% to 3.5%, based largely on the interest-rate gap between the United States and Japan. That compares with roughly 5% to 6% in 2024, when the interest-rate differential was considerably wider.

Following yen-buying intervention by Tokyo and Washington at the end of July, some carry-trade investors also appear to have shifted toward the Swiss franc as a funding currency.

How did the yen become a major funding currency?

The modern version of the yen-funded carry trade expanded significantly from 2013, when former Prime Minister Shinzo Abe’s economic policies included aggressive monetary easing by the Bank of Japan.

The strategy gained even greater momentum in 2022 and 2023. The U.S. Federal Reserve raised interest rates sharply to combat inflation while the BOJ maintained negative short-term rates, widening the yield gap between the two economies.

At the same time, the yen weakened significantly, providing an additional incentive for investors borrowing in yen and investing in higher-yielding currencies and assets.

How large is the yen carry trade?

The precise size of the yen carry trade is difficult to determine because many positions are privately held and can involve derivatives and leverage.

However, indicators suggest the scale is substantial. Reuters cited a Jefferies analysis of Bank for International Settlements data showing that cross-border yen borrowing reached a record 360 trillion yen, or about $2.34 trillion, in March. The analysis described this as the largest build-up of yen-funded carry trades in roughly three decades.

Another gauge is speculative positioning in the currency market. Data from the U.S. Commodity Futures Trading Commission showed that net short positions in the yen stood at 92,227 contracts in the week ended September 1. While that marked a third consecutive weekly increase, it remained well below the two-year high of 163,412 contracts recorded in the week ended July 1.

The actual size of carry-trade exposures could be significantly larger because hedge funds and algorithmic trading firms can employ leverage, Reuters noted.

Could the carry trade trigger another market shock?

A rapid reversal of yen-funded positions can have consequences well beyond the foreign-exchange market. When investors unwind carry trades, they need to buy back yen and sell the assets they purchased with the borrowed currency. A simultaneous rush to exit can therefore create sharp moves across currencies, bonds and equities.

Markets experienced such an episode in July 2024, when an unexpected BOJ rate hike triggered a rapid appreciation in the yen. The currency strengthened from around 154 yen per dollar to about 141 within days.

The resulting carry-trade unwind contributed to a broad sell-off in global equities. Japan’s Nikkei suffered a particularly severe blow, plunging 12.4% in a single session.

Why the current situation may be different

There are currently fewer signs of a disorderly unwind of the scale seen in 2024.

Reuters reported that BOJ policymakers have been signalling for weeks that another rate increase could be approaching, while also indicating that additional hikes may eventually be necessary. This has given investors more time to adjust their positions rather than being caught off guard by an unexpected policy move.

Equity markets have also largely absorbed the BOJ’s tightening signals alongside the yen’s appreciation. The relatively orderly movement in the Japanese currency suggests investors may already be repositioning ahead of next week’s meeting.

For global markets, the key question is therefore whether the yen’s rise remains gradual or develops into a rapid appreciation that forces highly leveraged investors to unwind positions simultaneously. A controlled strengthening of the yen could represent a broader shift in global capital flows, while a sudden reversal could once again expose the vulnerabilities created by years of cheap yen funding.