Tokyo, Sept 9 - The surge of Japan's currency to a seven-month high has reignited debate about whether the long-running yen carry trade is at an inflection point. The strategy - borrowing yen at low cost and deploying the proceeds into higher-yielding assets abroad - faces renewed pressure as market participants price in the possibility of accelerated Bank of Japan rate hikes, potentially beginning at the BOJ meeting next week.
How the carry trade functions
The carry trade relies on a simple mechanics: an investor borrows in a currency that has very low interest rates - historically the yen - and converts that funding into currencies or instruments offering materially higher yields. Typical destinations for that capital have included U.S. dollar-denominated assets, Mexican peso exposures, New Zealand dollar positions and a range of emerging market currencies. Investors then use those proceeds to buy bonds or other interest-bearing securities with the aim of pocketing the interest rate differential.
At the conclusion of a trade, usually after a short holding period, proceeds are converted back into the funding currency to repay the original loan. Current annualised returns on dollar-yen carry trades are typically around 2.5% to 3.5% - essentially the spread between U.S. and Japanese rates - with the potential for additional gains if the yen weakens during the holding period. By comparison, the same trade yielded roughly 5% to 6% in 2024.
Funding choices and recent shifts
For many years the yen was the funding currency of choice. That preference strengthened after 2013, when Japan's quantitative and qualitative easing under Prime Minister Shinzo Abe coincided with rising U.S. interest rates and a depreciating yen. The divergence between rapidly rising rates abroad and persistently very low - at times negative - short-term Japanese rates created fertile conditions for yen-funded carry positions.
Carry flows swelled further through 2022 and 2023, when the Federal Reserve raised rates quickly to combat inflation while the Bank of Japan maintained negative short-term rates and the yen weakened. However, after coordinated yen-buying intervention by Tokyo and Washington at the end of July, some carry practitioners appear to be shifting their funding currency preference toward the Swiss franc.
Sizing the trade - proxies and estimates
There is no precise tally of how large yen-funded carry positions are. The aggregate size is challenging to measure directly, but market proxies offer an indication. One estimate from a Jefferies analysis of Bank for International Settlements data showed cross-border yen borrowing rising to a record 360 trillion yen as of March, equal to about $2.34 trillion - the largest build-up of the past three decades according to that analysis.
Another gauge comes from speculative short positions on the yen. U.S. Commodity Futures Trading Commission data indicated net shorts on the yen of 92,227 contracts in the week to September 1 - a third consecutive weekly increase - but still below a two-year high of 163,412 contracts recorded in the week to July 1. Actual exposure tied to carry trades can be larger once leverage employed by hedge funds and algorithmic strategies is taken into account.
How this episode compares to the 2024 unwind
A sudden, large reversal of carry positions can ripple through global markets. That dynamic was on display in July 2024, when a surprise BOJ rate hike lifted policy to what was then a 15-year high and pushed the yen sharply higher from about 154 per dollar to roughly 141 in a matter of days. The rapid move forced many carry traders to liquidate positions and contributed to cascading sell-offs across equity markets, including a one-day 12.4% plunge in Japan's Nikkei.
At present, markets do not show signs of a comparable destabilising unwind. BOJ policymakers have publicly signalled for several weeks that a rate increase is likely soon and that additional tightening could be necessary. Equity markets have absorbed the tightening guidance and the yen's advance more evenly, and analysts point to the orderly nature of recent currency moves as an indication that investor positioning may be shifting in a more measured way ahead of next week's BOJ meeting.
Market participants will be watching closely as policy expectations evolve. For reference, the dollar was trading near 153.6700 yen at the time of these observations.
What this means for markets
- Fixed income and foreign exchange markets remain directly exposed to adjustments in carry-related funding flows.
- Equity markets are sensitive to rapid reversals of leveraged positions tied to the carry trade, as past episodes have demonstrated.
- Emerging market currencies and higher-yielding sovereign debt instruments are typical recipients of capital funded by carry trades and could be affected by shifts in funding patterns.
This overview outlines how the yen carry trade operates, why it expanded over the past decade, how large positions are inferred from available data, and why current developments differ in tone from the disruptive unwinding seen in 2024. Investors and policymakers alike will be attentive to BOJ communications and market reactions in the coming days.