As Japan's central bank tightens its monetary policy, investors who have been leveraging the yen to chase higher returns may be forced into a sudden unwinding of their positions. In early September, top currency experts at major Japanese banks received a flood of calls from investors and regulators alike, all asking the same two questions: just how large is the yen carry trade, and how close are we to a cascading liquidation? The brief answers from Tokyo's foreign exchange insiders — "no one can count it precisely" and "the risk is much closer than we thought" — did little to ease market anxiety.
The yen carry trade refers to a strategy where hedge funds and other investors borrow low-cost yen and invest those funds across global markets. For nearly three decades, investors have borrowed cheap, stable yen to pour into higher-yielding assets elsewhere, pocketing the spread. Until this month, the Bank of Japan's benchmark rate had not exceeded 1% since 1995, providing the ideal foundation for this strategy. However, the interest rate differential can narrow at any moment, or the yen exchange rate could move in an unexpected, rapid fashion. If investors suddenly rush to unwind their carry positions and sell the assets they bought, it could trigger violent turbulence across global markets, impacting everything from emerging market bonds and Nasdaq stocks to cryptocurrencies and prime real estate.
It is for this reason that the health of the global economy is deeply intertwined with the yen's trajectory, making the carry trade a barometer of market risk despite its notoriously low transparency. Masayuki Nakajima, a senior strategist at Mizuho Bank, notes that the yen carry trade stands out as one of the primary potential sources of market instability, a concern shared by overseas regulators. The last major upheaval in the carry trade occurred in 2024, when the Bank of Japan raised its rate clearly above zero for the first time in over a decade, triggering a sharp global sell-off. This time, however, the shockwaves could reach even further.
Where the real danger lurks
Tokyo-based experts have confided to global regulators that while the true scale is nearly impossible to measure, the current total size of the carry trade likely exceeds $2 trillion, probably hitting an all-time high. They add that the market's core worry is that cheap yen funding has been artificially suppressing US Treasury yields while simultaneously inflating an AI-related stock bubble. Numerous strategists have now ranked the risk of a concentrated carry trade unwinding as one of the top risks for the year. Nakajima notes that in recent weeks, a large number of analysts have been in communication with investors and regulators, and their focus is unmistakable: could a yen carry trade liquidation trigger a global sell-off?
While most analysts' base case does not involve a disorderly unwind, the urgency of this threat has risen significantly compared to six weeks ago. US Treasury Secretary Scott Bessent warned last month that disorderly yen moves could trigger forced liquidations and destabilize global markets. This was also the rationale behind the joint US-Japan intervention in late July to prop up the yen. That intervention stabilized the exchange rate after the yen had fallen to a 40-year low, with short-term traders heavily shorting the currency. But some now worry that further intervention, coupled with US pressure on the Bank of Japan to accelerate rate hikes — even after Tokyo raised its rate to 1.25% last Friday — could actually trigger the very unwinding policymakers are trying to avoid.
Analysts like Mizuho's Nakajima believe the market is underestimating the liquidation risk. Investors and regulators have an incomplete understanding of this trade, including who the key participants are and the logic behind its recent expansion. Nakajima points out that viewing the 2026 yen carry trade requires a much broader perspective: it now funds not only leveraged speculation but also serves as a source of capital for real-world corporate strategy. Previously, the carry trade was primarily a game for short-term speculators, long favored by Japan's "Mrs. Watanabe" cohort — individual investors who, faced with ultra-low domestic rates, shifted their yen savings into higher-risk, higher-yield assets overseas.
Today, however, large Japanese corporations have entered the fray at scale: hundreds of flagship companies, seeking growth beyond their shrinking domestic market, are using cheap yen to fund a combined $2 trillion in transformation investments. "Japan is the largest foreign direct investor in the United States. If that flow reverses, it's not just a shock to the global economy, but global markets will feel it significantly," says Nakajima. This capital structure, combined with the normalization of monetary policy after decades of unconventional easing, is fundamentally altering the pricing logic of the yen carry trade. Investors say that while the carry trade has long followed and amplified global market trends, a completely new era may now be dawning.
Some investors describe the yen carry trade as looking flawless right up until the moment risk hits. Borrowing in a stable, low-interest market and investing elsewhere for higher, steady returns is basic global finance logic. But the trade demands constant vigilance, as it is highly vulnerable to currency swings, government intervention, and sudden market bets on central bank policy shifts. For most of the past two decades, Japan happened to provide just such an ideal environment.
Why the next blow-up could be bigger
Financial regulators and major institutions typically ignore the carry trade's fragility until it is exposed. Historically, the trigger for several sharp crashes has been a rumor about central bank policy, combined with a single data point. Traders in Tokyo, London, and New York say the current environment feels remarkably similar. A concentrated carry trade unwind often brings cascading collateral damage. In 1998, it was a key factor in the collapse of the Long-Term Capital Management hedge fund; in 2007, it played a central role in the "quant quake" that many consider a precursor to the following year's global financial crisis. Then came the events of summer 2024, which the Bank for International Settlements (BIS) studied extensively for its global impact and regulatory lessons.
In early July of that year, rumors that Japanese authorities might intervene in the market triggered a rebound in the persistently weakening yen. A subsequent BIS report noted that this changed the profit expectations of numerous leveraged speculators. Market volatility began to appear. After months of gains, tech and AI stocks crashed on July 24, erasing billions in market value overnight; the yen strengthened sharply, directly satisfying the conditions for a mass carry trade unwinding. The final trigger was a hawkish rate hike from the Bank of Japan, combined with a weaker-than-expected US jobs report. That US employment data could hardly be read as a clear sign of deteriorating economic prospects, let alone a recession, the BIS report said, but markets had become highly sensitive to any sign of shifting growth momentum or monetary policy expectations. What followed was exactly what regulators and investors fear most now: a concentrated liquidation of leveraged positions and carry trades sent shockwaves rippling across the globe. Japan's TOPIX index plunged 12% in a single day, with stock markets in the US, Europe, and Asia all falling sharply. Bitcoin, a barometer of yen-funded risk-taking permeating global markets, dropped 16% within days. The Mexican peso and other emerging market currencies that had long hosted yen-funded bets plunged violently as positions were closed. Some markets recovered later that week, but current worries suggest a rebound may not come so easily this time.
How much have these leveraged speculative carry trades ballooned since 2024, and how precarious is the current risk? The scale of the carry trade has always been notoriously difficult to measure precisely. Hedge funds make heavy use of off-balance-sheet derivatives, keeping most of their trading hidden from regulators; even if the total volume of yen borrowing could be observed, tracking where those funds are invested is nearly impossible. Data from the US Commodity Futures Trading Commission (CFTC) offers only a partial view: yen short positions surged in 2021, were unwound between late 2024 and early 2025, were rebuilt through 2026, and have only begun to be reduced again in the past two weeks. Kit Juckes of Société Générale notes that low USD/JPY volatility typically signals that a liquidation phase has already entered its early stages.
Shrikant Kale, a quantitative analyst at Jefferies, estimates that cross-border yen borrowing outstanding across hedge funds, banks, corporations, and households grew by 67% between December 2021 and March 2026, reaching 360 trillion yen (approximately $2.3 trillion). In a recent research note, Kale stated that this surge represents a massive accumulation of yen-leveraged positions, calling this cycle the largest carry trade expansion in three decades and highlighting the potential risk of a disorderly unwind facing global markets. Kale adds that only two historical periods are comparable: 2003 to 2007 and 1995 to 1997. Both cycles ultimately ended in violent, painful carry trade liquidations.
The new wildcard no one is tracking
What makes this cycle different is the role of Japanese corporations. Previous calculations of the carry trade scale rarely factored in Japanese corporate overseas investment. But companies, benefiting from both ultra-cheap yen funding and a persistently strong dollar, have refrained from hedging their currency exposure on overseas investments, allowing their foreign asset holdings to accumulate to unprecedented levels. According to Citigroup data, Japan's outward foreign direct investment stock — including equity, retained earnings, and debt capital — reached 384 trillion yen in 2025, rising from 20% of GDP in 2014 to over 50% today. Citi estimates that Japanese non-financial corporations now hold more overseas assets than banks, pension funds, and insurance companies combined. Osamu Takashima, Citi's chief FX strategist, says this is essentially a type of yen carry position, and its continued accumulation puts downward pressure on the yen.
Analysts say the yen carry trade poses global risks over both the short and long term. The short-term risks are clear: first, the $96 billion US-Japan intervention in the dollar-yen rate this summer could mark a turning point for the yen; second, the Bank of Japan could raise rates more aggressively than the market expects, driving a sharp yen appreciation — the dollar is currently trading around 157 yen — and undermining the fundamental logic of speculative carry trades. The long-term risk is more complex, but once set in motion, its impact will be far more profound. Japan is emerging from decades of deflation, and the central bank has ended years of easing, breaking the market's long-held belief that yen can be borrowed at ultra-low cost indefinitely to chase risk assets. With Japan's policy rate at 1.25% and headline inflation at 1.7%, these figures are not high by global standards. Traders say the vast gap from what markets expected for years is felt every single day.
Monetary policy normalization means rates are likely to keep rising for some time, which will attract corporations and financial institutions that have long bought dollar assets back to Japanese domestic assets. For years, speculative carry trades combined with heavy corporate overseas investment have kept the yen suppressed. Analysts now must confront the possibility of a reversal in capital flows — although many believe Japanese households and corporations are conservative and capital will not return quickly. But the mere fear of such a reversal could be enough to trigger a carry trade unwinding, as investors reassess the safety margins on their existing positions. Citi's Takashima says that once the market begins to question these overseas dollar positions, the scale of hedging operations and capital repatriation could reach unprecedented levels.
Analysts point to a new variable in assessing unwind risk: Bessent's intense focus on the yen exchange rate, Bank of Japan policy, and Japanese Prime Minister Takayuki Hagiuda's efforts to stimulate the domestic economy. One of Bessent's biggest concerns is that for years, the carry trade has suppressed US Treasury yields to a large degree, with risk-averse carry funds consistently buying US government bonds. A rapid reversal of the carry trade, or a large-scale, gradual repatriation of Japanese capital lured by domestic bond yields at multi-decade highs, would put enormous pressure on Bessent and finance ministers worldwide. During Japan's domestic low-yield era, the country served as a stable, massive absorber of sovereign debt from developed economies. Some analysts believe the motive behind the US intervention in July was to prevent the yen and Treasuries from falling in tandem, staving off Japanese selling of US bonds and a large-scale repatriation of domestic investors' capital.
Earlier this month, Bessent further escalated his tough rhetoric, warning speculators against shorting the yen, declaring "now I'm the house," and suggesting he has a fairly good read on the Bank of Japan's policy direction. One school of thought holds that Japan's rate normalization will end the yen's long-standing role as the world's funding currency. The other major funding currency, the Swiss franc, has fallen sharply in recent months as the Swiss National Bank holds rates at zero while other major central banks hike. Barry Eichengreen, a professor of political economy at UC Berkeley, sums it up this way: as Japanese rates finally normalize, the era of the yen as a funding currency has come to an end.
But a significant number of observers hold the opposite view. Japan's economy remains weighed down by multiple structural weaknesses, with demographics being the most prominent, constraining rapid rate hikes. The US-Japan interest rate differential is likely to remain substantial. Last week, the Federal Reserve completed its first rate hike since 2023, raising rates to the 3.75%-4% range and signaling further increases to combat inflation. The Bank of Japan hiked last Friday and signaled more to come, yet the yen still fell, a clear reflection of fragile market sentiment. With both central banks tightening in sync, markets have dubbed it a "rate hike race."
Analysts say that as the impact of Bessent's rhetoric and the US-Japan joint intervention gradually fades, the underlying logic of the carry trade remains intact. Shoki Omori, chief rates strategist at Deutsche Bank in Tokyo, finds it strange that so many people immediately declared the yen carry trade dead after intervention pushed the yen higher. "Market structures don't change easily," he says.
Comments