Surging Yen Sparks Carry Trade Unwind Ahead of BOJ Decision

By Ankur Banerjee and Rocky Swift

SINGAPORE (Reuters) — A powerful surge in the Japanese yen ahead of the anticipated interest rate hike from the Bank of Japan next week is disrupting the long-established and highly lucrative carry trade, forcing investors to reassess the outlook for the volatile currency.

Early signs of capital repatriation, combined with expectations for faster monetary tightening by the Bank of Japan and U.S. pressure, are driving the yen higher. The currency hit 40-year lows in July, which prompted a joint U.S.-Japan intervention.

This sharp spike is also triggering an unwinding of the popular carry trade—where investors borrow low-cost yen to invest in higher-yielding currencies and assets—as traders brace for upcoming central bank policy meetings in both Japan and the United States.

“The carry trade is highly vulnerable because this unwind is occurring before the Bank of Japan has even implemented its anticipated rate hike,” said Charu Chanana, chief investment strategist at Saxo.

“While some short-yen positions have already been closed, market positioning remains substantial. Consequently, further yen appreciation could transform a gradual reduction in leverage into a rapid, self-reinforcing unwind.”

Although the precise scale of the yen carry trade is difficult to quantify, analysts analyzing market data suggest substantial capital is tied up in this strategy. A sudden, disorderly unraveling could easily jolt global financial markets, reminiscent of the volatility seen in August 2024.

CROSS-BORDER BORROWING SURGES

Cross-border yen borrowing, a key proxy for the carry trade, surged to a record 360 trillion yen ($2.35 trillion) as of March, according to a Jefferies analysis of Bank for International Settlements data. This represents the largest carry-trade accumulation of the past three decades.

Assuming Japanese Prime Minister Sanae Takaichi would maintain loose monetary policy alongside her fiscal stimulus, “the yen carry trade participants took on excessively large positions, and the unwinding of these positions is now accelerating,” said Akira Moroga, chief market strategist at Aozora Bank.

The yen strengthened to its highest level since February at 152.89 per dollar on Tuesday, marking a rapid reversal from around 160 just a week prior. This sharp move has reignited concerns over potential currency intervention.

“The break below the 155 level appears to have triggered another wave of yen short-covering, with both leveraged funds and real-money investors reducing their short-yen exposure,” said Masahiko Loo, senior fixed-income strategist at State Street Investment Management in Tokyo.

Analysts attribute this dramatic surge to stop-loss orders—automatic instructions to buy or sell once a currency hits a specific threshold—being triggered, which accelerated the dollar/yen move.

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This rally was broad-based, with the yen rising nearly 5% against typical carry trade favorites so far in September, including the Mexican peso and the Turkish lira.

Volatility poses a significant risk to carry trades, as rapid currency fluctuations can easily erode yield advantages. The three-month implied volatility for dollar/yen, a measure of expected price movements derived from options pricing, has surged to its highest level in six months, marking its sharpest week-over-week increase in two years.

“A further unwind could push USD/JPY toward the mid-140s given the substantial outstanding short positions,” Loo noted, adding that investors are increasingly pricing in a more hawkish path for the Bank of Japan. “That said, this is no longer just a positioning story.”

Currently, market odds stand at 97% that the Bank of Japan will raise its key interest rate by 25 basis points to 1.25%, according to Tokyo Tanshi data, up significantly from 52% a month ago. The data indicates a 27% probability of a rate hike in October and 61% odds in December.

TRADERS WARY OF 2024 ECHOES

The risks of a disorderly unwinding were starkly illustrated in 2024, when a surprise Bank of Japan rate hike sent the yen soaring, forcing traders to dump carry trades and sending shockwaves through global financial markets for days.

However, analysts argue that the situation is different this time. Investors are bracing for a sustained, hawkish policy shift from the Japanese central bank and are unlikely to be caught off guard, having learned the lessons of past market disruptions.

Kenneth Goh, director of private wealth management at UOB Kay Hian, noted that during the 2024 yen rally, capital had nowhere to go. “That is what has changed. Money no longer has to leave Japan to earn a return,” Goh said, pointing out that the 10-year Japanese government bond yield is hovering near its highest level in 30 years.

“Whether this represents a genuine trend or another short squeeze will be answered only after September 18, not before. If the yen maintains its gains following the rate hike, the funding side has genuinely repriced.”

That said, there is a prevailing fear that market expectations may be set too high for Bank of Japan Governor Kazuo Ueda to fulfill. Disappointed market participants could just as quickly drag the yen lower.

Citi’s FX sales desk remarked that market expectations are running too high, as the Bank of Japan is unlikely to want to repeat the summer of 2024.

“That said, in a world where every policy meeting is genuinely ‘live,’ I would expect the strategy of remaining short JPY until the next hike meeting to shrink,” it noted.

For the time being, traders are choosing to retrace their steps, as the pivotal central bank meetings next week could dictate the future trajectory of both the yen and the carry trade.

“Many traders remain reluctant to aggressively rebuild yen short positions given the intervention risk,” State Street’s Loo said. “The carry trade still functions, but it is no longer a free lunch. It now comes with a political risk premium.”

($1 = 153.2100 yen)

(Reporting by Ankur Banerjee and Rae Wee in Singapore, Rocky Swift and Atsuko Aoyama in Tokyo, and Jiaxing Li in Hong Kong; additional reporting by Alun John in London; Editing by Thomas Derpinghaus and Kate Mayberry)

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