In recent months, the carry trade on the Japanese yen has once again become a prominent topic of discussion. Although technically complex, this strategy plays a crucial role in global liquidity flows. Its trajectory, now more than ever, serves as an indicator of the stability — or fragility — of international financial markets.

What is the carry trade

The carry trade consists of borrowing funds in a currency with very low interest rates and investing them in assets denominated in currencies offering higher yields.

The profit derives from the interest rate differential, that is, the difference between the cost of financing and the return generated by the investment.

As long as exchange rates remain stable and the differential stays wide, the strategy can prove highly profitable. However, its equilibrium is extremely sensitive: a shift in rates or a sudden move in the exchange rate is sufficient to reverse the outcome entirely.

Why the yen is the benchmark funding currency

The Japanese yen has traditionally been regarded as the funding currency par excellence in the world of carry trade.

For over two decades, the Bank of Japan (BoJ) maintained an ultra-accommodative monetary policy to counter deflation and support growth, keeping interest rates at or even below zero.

In this context, borrowing in yen was extremely cost-effective: international investors were able to convert the low cost of Japanese money into leverage for financing positions in government bonds, corporate bonds, equities, or higher-yielding currencies.

A (cautious) change of course from the BoJ

After years of inaction, the Bank of Japan has begun — with great caution — a phase of monetary normalisation.

From spring 2024, interest rates returned to slightly positive territory (around 0.25–0.5%) and the institution led by Kazuo Ueda signalled greater attention to inflationary risks.

This change, although marginal in absolute terms, is sufficient to alter the risk perception associated with the yen carry trade.

The yen, having weakened to around 160 against the dollar, has shown signs of recovery, also driven by expectations of further rate rises and possible verbal interventions by the BoJ in the currency market.

The risks of the mechanism

The yen carry trade is profitable only as long as the Japanese currency remains weak.

A sudden appreciation — perhaps triggered by a change in monetary policy or by geopolitical tensions — can force investors to close their positions and buy back yen to repay their loans, generating cascading sell-offs across other assets.

This phenomenon, known as carry trade unwinding, has been observed during several phases of stress in global markets, such as the financial crisis of 2008 or the early stages of the pandemic in 2020.

According to some analysts, a similar movement — albeit of lesser magnitude — could recur should the yen continue to appreciate.

Repercussions on international markets

The yen carry trade represents one of the principal sources of “shadow” liquidity that feeds financial markets.

When the strategy is in full swing, investors tend to move towards riskier assets, supporting prices in equities, high-yield bonds, and emerging market currencies.

Conversely, a phase of carry trade unwinding can generate a capital outflow and a sharp increase in volatility, particularly in market segments most exposed to international speculative flows.

Many observers believe that this dynamic may amplify movements already under way rather than create new ones: the carry trade is not the cause of market cycles, but it often exacerbates their effects.

An evolving scenario

At present, the BoJ is proceeding with extreme gradualism, seeking to avoid destabilising currency and bond markets. However, the room for manoeuvre remains limited: on one hand, Japanese inflation is proving more persistent than expected; on the other, an excessive rise in rates risks undermining the fragile domestic economic recovery.

The consequence is that the yen carry trade remains a precarious equilibrium, influenced as much by decisions taken in Tokyo as by those in Washington.

As long as the differential between US and Japanese rates remains wide, the strategy may continue to attract capital. But the risk of a sudden reversal remains ever-present.

In summary

  • Rationale: exploiting the rate differential between the yen (low) and other currencies (higher).
  • Context: the BoJ has begun a cautious monetary normalisation.
  • Main risk: a sudden yen appreciation can trigger forced position closures.
  • Potential effects: increased volatility and liquidity outflows from global markets.
  • Current scenario: a phase of unstable equilibrium, with close attention to the BoJ’s and the Fed’s next steps.