Global Market: Yen rally threatens to unravel lucrative carry trade ahead of BOJ rate decision

The Japanese yen’s sharp rally ahead of an expected Bank of Japan interest rate hike next week is disrupting the long-established carry trade, prompting investors to reassess the outlook for the volatile currency, Reuters reported.

Early signs of capital repatriation, expectations of a faster pace of monetary tightening by the BOJ and pressure from the United States are combining to support the yen, which fell to 40-year lows in July and prompted a joint US-Japan intervention.

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The yen’s surge is also encouraging investors to unwind carry trades ahead of monetary policy meetings in Japan and the United States. The strategy typically involves borrowing yen at relatively low interest rates and investing in currencies and assets that offer higher returns.

The scale of the yen carry trade is difficult to determine, but analysts have pointed to data suggesting that substantial amounts of capital remain tied up in the strategy. A rapid unwinding could create volatility across global financial markets, as happened during the sharp market turmoil in August 2024.

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Cross-border yen borrowing, viewed as a proxy for the carry trade, reached a record 360 trillion yen ($2.35 trillion) as of March, according to a Jefferies analysis of Bank for International Settlements data cited by Reuters. That represented the largest build-up of the trade in roughly three decades.

Analysts said investors had accumulated large yen-short positions on expectations that Japanese monetary policy would remain accommodative alongside fiscal stimulus. Those positions are now being reduced at a faster pace as expectations for further BOJ tightening increase.

Yen strengthens sharply

The yen strengthened to 152.89 per dollar on Tuesday, its strongest level since February, marking a rapid turnaround from levels around 160 just days earlier. The move has also revived concerns about the possibility of another intervention in currency markets.

Reuters reported that the break below the 155-per-dollar level appears to have accelerated yen short-covering, with both leveraged funds and longer-term investors reducing bearish positions on the Japanese currency.

Stop-loss orders, which automatically trigger trades once predetermined price levels are reached, are also believed to have intensified the move in dollar-yen trading.

The yen’s gains have been broad-based. It has risen nearly 5% so far in September against major carry-trade currencies such as the Mexican peso and Turkish lira.

Analysts cited by Reuters said a further unwinding of yen-short positions could push the dollar lower against the Japanese currency toward the mid-140s. However, the move is increasingly being viewed as more than simply a positioning adjustment, with expectations for a more hawkish BOJ becoming a key driver.

Markets price in BOJ rate hike

Financial markets are now pricing in a high probability of a BOJ rate increase next week. Tokyo Tanshi data showed the odds of a 25-basis-point hike to 1.25% at 97%, up sharply from 52% a month earlier.

Markets are also assigning a 27% probability to a rate increase in October and 61% odds of a move in December, according to the data.

The shift reflects growing expectations that the BOJ could pursue a more sustained tightening cycle after years of ultra-loose monetary policy.

Traders wary of repeat of 2024 turmoil

The potential risks of an abrupt carry-trade unwind were highlighted in 2024, when a BOJ rate hike triggered a sharp yen rally and forced investors to unwind leveraged positions. The resulting market moves reverberated across global equities, currencies and other risk assets.

This time, however, investors appear better prepared for the possibility of further BOJ tightening. Reuters reported that traders and analysts believe the market has already begun adjusting to the prospect of a more hawkish central bank.

Another important difference is the changing Japanese bond market. The 10-year Japanese government bond yield has been trading near its highest level in three decades, reducing the incentive for Japanese investors to send capital overseas in search of higher returns.

This means the direction of the yen after the BOJ’s September 18 meeting could be particularly important. A sustained yen gain following a rate hike would suggest that the funding cost underpinning the carry trade has undergone a more fundamental repricing.

Risk of yen reversal remains

Despite the yen’s recent strength, markets remain vulnerable to a sharp reversal if the BOJ fails to meet elevated expectations for monetary tightening.

Some analysts believe investors may have moved too far in pricing a hawkish policy path, particularly given the BOJ’s caution following the market turmoil of 2024.

Nevertheless, expectations of more frequent and meaningful policy shifts could make the traditional strategy of remaining short on the yen until the next BOJ meeting less attractive.

For now, traders are reducing yen-short positions ahead of next week’s crucial central bank meetings. The BOJ and U.S. Federal Reserve decisions could determine whether the yen’s recent advance develops into a sustained trend or proves to be another temporary squeeze.

The changing dynamics mean that the yen carry trade remains viable, but with greater currency, policy and political risks than in previous years.