The yen carry trade, where investors borrow yen at low interest rates to invest in higher-yielding assets like US stocks and bonds, is currently in its best environment since 2000. This is largely due to the substantial gap in interest rates between Japan and other developed economies, alongside relatively low currency volatility. This trade has channeled significant capital into US markets, boosting liquidity and asset prices, but some Wall Street professionals are growing uneasy about its inherent risks and potential for market disruption.
Several factors could jeopardize the stability of the yen carry trade. Japan's yen recently hit a 40-year low against the dollar, trading around ¥162 this week. Concerns are mounting that the Japanese government might intervene to strengthen the currency, a move that could erode profits for those engaged in the carry trade. Analysts at Morgan Stanley note that ¥160 often acts as a critical level triggering Bank of Japan action. Furthermore, rising inflation in Japan could lead the Bank of Japan to raise interest rates, which would increase borrowing costs for yen and potentially cause investors to unwind their dollar-denominated assets.
An unwind of the yen carry trade carries significant risks for global markets. A previous unwinding in August 2024, following a surprise rate hike by the Bank of Japan, led to a sharp decline in US stocks and the worst day for Japanese stocks since 1987. David Morrison, a senior market analyst at Trade Nation, warns that an "unruly unwind" could inflict "widespread damage." Albert Edwards, a SocGen strategist, suggests that such an event could impact the AI trade and highlights the increasing importance of Japanese monetary policy on US asset prices. JPMorgan also points to risks from "excessive yen depreciation" and sharp increases in Japanese interest rates, which would bolster the yen's value.
Despite the risks, the carry trade has been performing strongly. Citi estimates that buying the five G10 currencies with the highest rates and selling the five with the lowest, without leverage, would have yielded over 4% so far this year. However, some analysts, like Robin Brooks of the Brookings Institution, caution that Japan's efforts to cap bond yields while intervening in currency markets are contradictory and ultimately "doomed to fail" against a backdrop of a "quiet implosion" driven by the country's ballooning debt, which stands at 240% of GDP. Japan's need to liquidate US Treasuries to defend the yen could also drive up US borrowing costs and destabilize global markets.
Former Japanese central banker Tsutomu Watanabe speculates that Japanese interest rates could eventually rise above 2%. Japanese bond yields are already increasing, reflecting investor anxiety over the country's fiscal health, with the 10-year government bond yield up 150 basis points in the past year. These underlying pressures suggest that while the carry trade conditions are currently favorable, they are built on a potentially unstable foundation.
