Should We Worry About a Reversal of Yen Carry Trades?

If the U.S. economy weakens more than expected, the asset side will be the trigger for a concentrated unwinding of carry trades.

Written by: Wu Shuo, Lin Yan, Wall Street Watch

On September 3, the Bank of Japan raised interest rates as expected, but the increase was less aggressive than the market had anticipated, allowing the market to take a brief breath. Previously, the yen had rapidly appreciated, and with Bank of Japan officials frequently releasing hawkish signals, the market was once again reminded of the reversal of carry trades in 2024—when global assets faced widespread selling, leaving a deep “shadow” on the market and causing lingering concerns about this rate hike by the Bank of Japan.

However, the Bank of Japan is not as hawkish as previously expected by the market. Although Governor Ueda did not rule out the option of consecutive rate hikes during the post-meeting press conference, he left room for the pace of rate hikes. Coupled with the absence of significant negative external factors (the U.S. non-farm payroll data for August was robust, and oil prices were declining), the impact of this rate hike on the global market was limited, leading to a broad rally in Asia-Pacific stock markets, while the yen further weakened after the rate hike.

However, market concerns have not completely dissipated. As the Bank of Japan continues its rate hike process, the cost of yen financing is rising, gradually diminishing the yen's attractiveness as a funding currency for global carry trades. Nevertheless, we believe that the risk of a concentrated reversal of yen carry trades in the short term has receded, with funds likely showing a more gradual return, making the overall spillover impact manageable.

Essentially, yen carry trades are driven by three interconnected factors: the financing side, the exchange rate side, and the asset side: on the financing side, borrowing low-interest yen, with funding costs determined by the Bank of Japan's policy rate; on the exchange rate side, converting borrowed yen into dollars, where exchange rate fluctuations directly impact the principal's exchange gains and losses; on the asset side, using dollars to invest in high-yield assets such as U.S. Treasuries and U.S. stocks, earning interest rate spreads and capital gains from the asset side.

Therefore, a large-scale unwinding of carry trades often requires the resonance of three conditions: sustained rate hikes by Japan raising yen financing costs, rapid and significant appreciation of the yen leading to exchange losses, and declining prices of dollar-denominated assets compressing profit margins.

Currently, while there have been some marginal changes in the three factors, the catalytic conditions for triggering a comprehensive unwinding have not yet formed:

On the financing side, although the Bank of Japan has begun raising rates, its overall stance remains cautious, and it will not quickly raise yen financing rates. The fundamental constraints and fiscal restrictions within Japan are issues that the Bank of Japan cannot avoid, thus lacking the basis for rapid and significant rate hikes (this is even more evident compared to the U.S.).

The core profit from carry positions comes from the U.S.-Japan interest rate differential. Although the attractiveness of yen financing is weakening, the U.S.-Japan interest rate differential remains relatively high (the 10-year differential is still around 200 basis points), which will not quickly erode the profit margins of carry trades in the short term. Traders still have time to adjust leverage and gradually reduce positions, making concentrated passive unwinding unlikely.

On the exchange rate side, what matters is not just the level of the yen but also the speed of its appreciation. Only if the yen appreciates rapidly in the short term will it quickly generate exchange losses, forcing traders to unwind positions; if the yen strengthens slowly, the market has ample time to adjust positions, making a crash less likely.

Currently, the speed of yen appreciation has slowed: on one hand, due to fundamental constraints, the pace of rate hikes by the Bank of Japan may not be too fast; on the other hand, this round of rate hikes by the Bank of Japan resonates with the Federal Reserve's policy cycle, which to some extent constrains the narrowing of the U.S.-Japan interest rate differential, suppressing the momentum for rapid unilateral appreciation of the yen.

On the asset side, the core depends on global risk appetite and the performance of dollar-denominated asset yields. Carry trade funds ultimately flow into dollar assets such as U.S. Treasuries and U.S. stocks, which are the sources of profit for carry trades. If U.S. stocks undergo a significant correction and U.S. Treasury yields decline rapidly, the asset side's yields may shrink or even incur losses. Coupled with rising yen financing costs and exchange losses from yen appreciation, the combined pressure could easily trigger large-scale unwinding.

Currently, U.S. stocks and other high-yield dollar assets maintain overall resilience, and the macro environment and AI terminal demand have not shown systemic deterioration, allowing asset yields to still cover yen financing and exchange costs, lacking strong catalysts for concentrated exits.

In summary, the current pace of rate hikes by the Bank of Japan is cautious, the yen lacks a basis for unilateral sharp rises, and there are no systemic signals of a significant drop in overseas assets. Therefore, it is unlikely to replicate the severe unwinding impact of carry trades seen in 2024 in the short term.

Additionally, the congestion of yen depreciation trades has significantly decreased. Since the U.S.-Japan joint intervention, yen shorts have notably covered, and as of the week ending September 15, CME non-commercial yen short positions have decreased by about 56% from the late July peak, while long positions have surged by 135%, with net long positions since September also moving out of negative territory. Considering that some yen shorts have already covered in advance, the risk of rapid covering leading to concentrated unwinding of carry trades is relatively controllable.

The risk of a concentrated reversal of carry trades in the future needs to be closely monitored: whether the pace and magnitude of rate hikes by the Bank of Japan exceed expectations, and the speed and slope of yen appreciation in the short term. However, the most critical factor is that risks on the asset side are the core catalyst for triggering concentrated unwinding of carry trades.

This point can also be learned from the experience of the carry trade reversal in 2024. At that time, the market faced a similar environment of rapid yen appreciation and the Bank of Japan initiating rate hikes, but the final blow to carry positions came from the impact on the asset side due to the correction of global risk assets. Initially, the rise in yen interest rates and appreciation in 2024 only triggered gradual adjustments of positions; it was the rise in unemployment in the U.S. in August that triggered the Sam Rule, raising recession expectations, which ultimately led to systemic selling of global assets, accelerating the concentrated unwinding of carry trades and the appreciation of the yen.

Therefore, it is crucial to remain vigilant about potential tail risks in U.S. assets that could accelerate the reversal of carry trades. Key factors to observe include whether the U.S. economy continues to weaken more than expected, the escalation of geopolitical conflicts, increasing divergences in the AI sector, and severe fluctuations in the U.S. Treasury market, which may increase the risk of concentrated unwinding of carry trades in the short term.

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