The yen carry trade is cracking: Japan and the US are caught in the same rate trap

One of the largest and longest-running bets in financial markets is under pressure: the yen carry trade. The combination of a weak Japanese yen, sharply rising interest rates in both Japan and the United States, and recent interventions by both Tokyo and Washington is making this strategy increasingly vulnerable.

The heart of the problem: Japan wants a stronger yen, but has almost no policy tool it can use to achieve this without causing damage elsewhere.

Borrowing where it is cheap

At its core, the yen carry trade is simple. Investors borrow money in Japan, where interest rates are relatively low. They then convert the borrowed yen into dollars and invest the money in US bonds, equities or other assets with a higher expected return.

Suppose borrowing in yen costs 1% and a US Treasury bond yields 5%. That appears to earn an interest rate differential of 4 percentage points. As long as the yen remains stable or weakens further, this strategy works extremely well.

But a carry trade is really a double bet. The investment has to deliver enough, and the yen must not rise too much against the dollar. If the yen suddenly strengthens, more dollars are needed to repay the yen loan. The interest advantage built up over years can then disappear in a matter of days.

Japan is trapped

The weak yen is no accident. The interest rate gap between Japan and the United States is large and makes it attractive to move money out of Japan. That creates additional selling pressure on the yen.

For the Japanese economy, that weak currency is becoming increasingly problematic. Japan imports a great deal of energy and raw materials. These are usually paid for in dollars and therefore become more expensive when the yen weakens. That fuels inflation and hits households in particular through higher prices for fuel, electricity and everyday groceries.

Normally a central bank can support its currency by raising interest rates. But that is precisely where Japan is stuck. The Japanese government has one of the largest debt burdens in the world. Higher interest rates mean that refinancing that debt becomes ever more expensive. In addition, Japanese banks, insurers and pension funds could suffer losses on their large portfolios of existing government bonds.

Even so, Japanese interest rates are already climbing quickly. The ten-year yield reached almost 3% this week, the highest level in about thirty years. In effect, the market is forcing tighter financial conditions on Japan, even when the Bank of Japan wants to remain cautious.

The intervention in USD/JPY

The recent currency intervention cannot be seen separately from this dilemma. At the end of July, Japan and the United States intervened jointly to support the yen. In doing so, other currencies were sold and yen were bought. USD/JPY then fell sharply: one dollar temporarily bought considerably fewer yen.

Japan’s Ministry of Finance confirmed that the intervention had been carried out together with the US Treasury to counter “excessive” and “disorderly” movements in the yen. Tokyo also indicated that further interventions remain possible.

Such an intervention can deter speculators and put carry trades under temporary pressure. Investors who have borrowed yen see their repayment obligation quickly become more expensive when the currency rises. They may be forced to sell US bonds, equities and other investments and buy back yen. That amplifies the move.

But a currency intervention does not change the underlying interest rate differential. As long as US interest rates remain much higher than Japanese rates, the incentive to borrow yen and buy dollars persists. Intervention can buy time, but without a change in interest rate policy it is rarely a definitive solution.

The choice Washington fears

Japan holds enormous currency reserves and is among the largest foreign holders of US government bonds. In theory, Tokyo could fight a weaker yen by selling dollars and buying back yen. But when that requires selling US government bonds on a large scale, a new problem arises.

Additional selling of Treasuries pushes down bond prices and drives US long-term interest rates further up. That is exactly what Washington wants to avoid. The US government has to finance a rapidly growing national debt and therefore depends on sufficient demand for its bonds. Higher rates mean not only higher interest costs for the government, but ultimately also more expensive mortgages, corporate loans and consumer credit.

To avoid forced sales, Japan wants to make use of the US Federal Reserve’s FIMA Repo Facility. This allows Tokyo to temporarily borrow dollars using US government bonds as collateral, without selling those bonds directly on the market. Those dollars can then be sold to buy yen.

That explains why the United States cooperated in the intervention. Washington wants to prevent Japan from having to choose between an uncontrolled weak yen and selling large quantities of Treasuries.

Bessent tries to tame long-term rates

Against this backdrop, US Treasury Secretary Scott Bessent took another striking step on 19 August. The department announced that it would at least double the buyback of government bonds with maturities of 10 to 30 years. From 9 September, the maximum amount rises from $2 billion to at least $4 billion per operation.

The measure followed after the US 30-year yield had reached about 5.3%, the highest level since 2007. By buying back long-dated bonds, the Treasury creates additional demand. Bond prices rise as a result and yields fall. After the announcement, the 10-year yield eased towards 4.65% and the 30-year yield to about 5.2%.

With this, Bessent is trying to manage two flashpoints at once. Lower US interest rates relieve the US government and at the same time narrow the interest rate gap with Japan. That can reduce the pressure on the yen and lessen the appeal of the carry trade. After all, a stronger yen and lower US rates hit carry traders from two sides.

No painless way out

Ultimately, Japan has three options, and all three have clear drawbacks. It can raise interest rates and thereby support the yen, but risks higher interest costs and problems in the Japanese bond market. It can deploy currency reserves, but threatens to put the US bond market under further pressure. Or it can keep intervening with Washington’s support, while the fundamental cause, the interest rate differential, largely remains in place.

For retail investors, this is more than a technical currency story. When large professional players have to unwind their carry trades, they can be forced to sell equities, bonds, cryptocurrencies and other risky investments.

So watch three signals in particular: USD/JPY, the Japanese ten-year yield and the US 10- and 30-year yields. Sharp moves in these markets can be the first indication that the yen carry trade is being unwound further.

The key lesson: with the carry trade, returns are built up slowly, but losses can arise at lightning speed. Bessent and the Japanese authorities are trying to buy time. For now, there is no truly good solution to their shared rate trap.

Written by

Robbie van de Wijnckel

Senior Asset Manager

Robbie van de Wijnckel graduated in 2005 as MSc in Economics at the University of Tilburg, The Netherlands. He started his career as investment advisor for the private market at Fortis Bank Nederland. In 2009 he switched to Van Lanschot Bankiers to work as Fixed Income Analyst. In this role he closely followed the European corporate and government bond market. In 2012 Robbie decided to move to Luxembourg. As Senior Portfolio Manager with asset managers 2PM Luxembourg, he was responsible for the investment policy. In December 2017 he joined Andreas Capital where he fulfills the role as Senior Asset Manager. Robbie is a Chartered Financial Analyst of the CFA Institute since 2017.

Reinier Beelaerts van Blokland

Senior Asset Manager

Reinier Beelaerts graduated in 2008 with a master’s degree in engineering from Delft University of Technology. He started his career as a Quantitative Analyst at Swiss Life in Luxembourg in the department of Variable Annuities. Still at Swiss Life, he became a Senior Hedging Officer where he mainly focused on structuring derivatives transactions to hedge the underlying market risks. In 2018 he joined a single-family office as Investment Manager with a focus on investments across the capital structure of publicly listed companies. In April 2022 he joined Andreas Capital as a Senior Asset Manager. Reinier is a CFA charter holder since 2016.

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