The Japanese yen has recently climbed to a seven-month high, raising an important question for global investors: could the long-running yen carry trade be starting to unwind?
The strategy has been a major part of global markets for years. However, expectations that the Bank of Japan could accelerate interest-rate hikes are making the trade less attractive.
Here is how the yen carry trade works, why it matters, and what could happen if investors begin to exit their positions.
What Is the Yen Carry Trade?
The yen carry trade is a strategy in which investors borrow Japanese yen at relatively low interest rates and use the money to buy higher-yielding currencies or assets.
The aim is to profit from the difference between Japan’s low borrowing costs and the higher returns available elsewhere.
Investors may use borrowed yen to buy U.S. dollars, Mexican pesos, New Zealand dollars, or other currencies offering higher interest rates.
They can then invest the funds in bonds or other income-generating assets.
How Does the Yen Carry Trade Work?
The basic idea is relatively simple.
An investor first borrows yen at a low interest rate. The borrowed money is then converted into another currency with a higher interest rate.
The investor uses those funds to purchase higher-yielding assets.
At the end of the trade, the investor converts the proceeds back into yen and repays the original loan.
The profit mainly comes from the difference between the two countries’ interest rates.
If the yen also weakens during the trade, returns can become even larger because fewer units of the stronger foreign currency are needed to repay the yen loan.
Yen Carry Trade Returns Have Declined
Dollar-yen carry trades can currently generate annualized returns of around 2.5% to 3.5%, based mainly on the gap between U.S. and Japanese interest rates.
That is lower than the roughly 5% to 6% returns available during parts of 2024.
The decline reflects changes in monetary policy and the narrowing difference between U.S. and Japanese interest rates.
A stronger yen also increases the risk for investors using the currency as a funding source.
Why Has the Yen Been So Popular?
Japan has maintained unusually low interest rates for many years.
That made the yen one of the cheapest major currencies to borrow.
The modern version of the yen carry trade expanded significantly from 2013 under former Prime Minister Shinzo Abe.
Japan’s aggressive monetary easing coincided with rising interest rates in the United States and a weakening yen.
Those conditions made borrowing in yen and investing abroad particularly attractive.
The Carry Trade Expanded After 2022
The strategy became even more popular during 2022 and 2023.
During that period, the Federal Reserve rapidly raised U.S. interest rates to fight inflation.
At the same time, the Bank of Japan kept short-term interest rates negative.
The widening difference between U.S. and Japanese rates increased the potential return from yen-funded trades.
A weakening yen added another source of profit.
Investors May Be Turning to the Swiss Franc
Recent currency intervention and the yen’s rebound may be encouraging some investors to look for alternative funding currencies.
The Swiss franc has emerged as one potential replacement.
Like the yen, the franc can sometimes offer relatively low borrowing costs compared with higher-yielding currencies.
That makes it attractive for some carry-trade strategies when conditions in Japan become less favorable.
How Large Is the Yen Carry Trade?
There is no precise figure showing the total size of the yen carry trade.
The positions are spread across banks, hedge funds, institutional investors, and other market participants.
However, several indicators provide clues about its scale.
Cross-border yen borrowing reached a record 360 trillion yen, or about $2.34 trillion, as of March, according to an analysis based on Bank for International Settlements data.
That represented one of the largest buildups in yen borrowing in decades.
Yen Short Positions Offer Another Clue
Another way to estimate the size of the carry trade is to examine speculative positions in the yen.
Data from the U.S. Commodity Futures Trading Commission showed net short yen positions of 92,227 contracts in the week ending September 1.
That marked a third consecutive weekly increase.
However, the figure remained below the two-year high of 163,412 contracts recorded in early July.
Actual carry-trade exposure could be significantly larger because hedge funds and algorithmic trading strategies often use leverage.
Why Can a Yen Carry Trade Unwind Be Dangerous?
The biggest risk comes when the yen suddenly strengthens.
A rapid rise in the Japanese currency can quickly reduce or eliminate the profits generated from higher-yielding foreign assets.
Investors may then rush to close their positions.
To do this, they often need to sell the assets they originally purchased and buy yen to repay their loans.
If enough investors do this at the same time, the process can create sharp moves across global markets.
What Happened During the 2024 Yen Carry Trade Unwind?
A major example occurred in July 2024.
The Bank of Japan unexpectedly raised interest rates to their highest level in around 15 years.
The yen then strengthened rapidly, moving from roughly 154 per dollar toward 141 within days.
That forced many carry traders to unwind their positions.
The resulting sell-off affected global equities and other risk assets.
Japan’s Nikkei suffered an especially severe decline, falling 12.4% in a single session.
Why Is the Situation Different Today?
Current market conditions appear more orderly than during the 2024 episode.
Bank of Japan officials have been signaling for weeks that another rate hike could be approaching.
They have also suggested that additional increases may be needed later.
Because investors have had more time to prepare, the yen’s recent appreciation has not caused the same level of market stress.
Equity markets have also absorbed the Bank of Japan’s tightening signals relatively well.
Bank of Japan Policy Remains Crucial
The next Bank of Japan meeting could be a major test for the yen carry trade.
If policymakers raise rates and signal additional tightening, the yen could strengthen further.
That would reduce the attractiveness of borrowing in yen to invest elsewhere.
However, the impact will also depend on Federal Reserve policy.
If U.S. interest rates remain high, the gap between U.S. and Japanese rates could still provide some support for carry trades.
What Happens If the Yen Carry Trade Unwinds?
A gradual unwind would likely be manageable for global markets.
A sudden exit, however, could create much more volatility.
Investors could be forced to sell stocks, bonds, emerging-market currencies, and other assets to close leveraged positions.
At the same time, demand for yen could rise sharply as traders repay their loans.
This is why investors closely monitor changes in Japanese interest rates and movements in USD/JPY.
Why the Yen Carry Trade Matters for Global Markets
The yen carry trade is much more than a foreign-exchange strategy.
Because borrowed yen can be invested across stocks, bonds, currencies, and other assets, changes in the trade can affect markets around the world.
A stronger yen and tighter Bank of Japan policy could gradually reduce its appeal.
For now, investors are watching whether the latest yen rally develops into an orderly adjustment or the beginning of a much larger unwind.
