A potential interest rate increase by the Bank of Japan is drawing fresh attention to the yen carry trade — a popular global investment strategy that can unravel quickly when Japanese rates rise.
The Bank of Japan is once again at the center of global market attention, as expectations of a rate increase raise the prospect of a disruptive unwinding of the yen carry trade. For years, Japan’s near-zero interest rates made the yen a cheap funding currency, allowing investors worldwide to borrow cheaply in yen, convert the money into higher-yielding assets abroad, and pocket the difference. Any meaningful shift in Japanese borrowing costs can force those positions to reverse fast.
A carry trade works simply: borrow where rates are low, invest where rates are high. The yen has long been the funding currency of choice for this strategy. When the Bank of Japan holds rates near zero, the math is attractive. But when Japanese rates rise — or when traders expect them to — the yen tends to strengthen. That makes it more expensive to repay yen-denominated borrowing, and investors rush to exit the trade at the same time, amplifying market moves.
Markets got a sharp reminder of how quickly this can happen in the summer of 2024, when an unexpected Bank of Japan rate move sent the yen surging and triggered a sudden, broad sell-off in global equities and risk assets. The episode showed how deeply the carry trade is woven into global financial positions.
Now, with the Bank of Japan signaling a continued willingness to normalize policy — moving away from decades of ultra-loose monetary settings — investors are watching closely for any fresh rate action. A rate hike, even a modest one, could strengthen the yen further and pressure the large pool of carry positions that still exists across global markets.
The size of the carry trade at any given moment is difficult to measure precisely, but analysts generally regard it as significant enough to cause broader turbulence if unwound rapidly. Assets that benefited from cheap yen funding — including equities in the United States, parts of emerging markets, and higher-yielding bonds — could face selling pressure if traders move to cover their positions.
The Bank of Japan’s path matters well beyond Japan’s borders. As one of the last major central banks to exit emergency-era low rates, its policy moves carry outsized weight for global capital flows.
Investors will be watching Bank of Japan communications carefully for any signals that a rate move is imminent and what it could mean for currency and risk markets worldwide.
