A rapid unwind of the Japanese yen 'carry trade' could trigger a stock selloff, particularly hurting high-valuation U.S. tech names
Wall Street's AI boom has a hidden risk: The Japanese yen.
Traders on Wall Street have wagered easy money for years on a very simple bet: borrowing in Japan for next to nothing, and using it to chase bigger returns elsewhere - mainly in the U.S. stock market.
That bet is now at risk of coming undone. The recent surge in the Japanese yen against the dollar, and a widely expected interest-rate increase by the Bank of Japan next week, could deal a blow to the popular trade, known as the yen "carry trade." It wasn't so long ago that a previous unwind sent Wall Street into a tailspin, and it could do so again.
The Japanese yen (USDJPY) on Tuesday extended its rally against the U.S. dollar - hitting a session low of -Yen152.89 per buck, its strongest level since February. Market expectations that the Bank of Japan will deliver an aggressive rate hike next week have been driving the rally, while there's also been speculation that Japanese authorities might quietly intervene again in foreign-exchange markets to curb the yen's recent downturn.
The currency just last week crossed below the 160-per-dollar mark - a level often seen as a key threshold increasing the chance of government intervention. The yen has gained nearly 4% so far in September against the greenback, according to FactSet data.
Against that backdrop, the market's momentum could leave stock investors exposed to a shock that they might not see coming: a continued strengthening of the yen and a fast unwind of the carry trade.
A carry trade is a strategy where investors borrow money at a lower interest rate to invest in assets with potentially higher returns. The yen carry trade involves borrowing lower-yielding yen to buy higher-yielding U.S. dollars, then using those dollars to invest in U.S. assets such as technology stocks.
As an example, the yield on 1-year Japanese government bonds JP:TMBMKJP-01Y is 1.55%, while the yield on 1-year U.S. Treasury notes BX:TMUBMUSD01Y is 4.12%. Basically, the yen carry trade can boost returns by 2.57 percentage points.
Yet the trade could work as powerfully in reverse. If the yen suddenly strengthens further - like what happened in recent days - investors could be forced to unwind those positions rapidly. That might mean selling assets denominated in the U.S. dollar so investors can repay their yen-based loans.
Markets saw this pain not so long ago. A jump in the yen during the summer of 2024 rattled stock markets, with the unwind of the carry trade jeopardizing high-flying U.S. tech stocks in particular.
Fast-forward to today and the foreign-exchange markets may be perfectly set up for a repeat, as the Bank of Japan is expected to raise interest rates, and that alone could strengthen the yen.
Such an unwind "could be especially painful for the AI/tech complex, where high valuations and crowded positions could amplify a potential selloff," said Ipek Ozkardeskaya, senior analyst at Swissquote.
"I would say that would open the door to dip-buying opportunities, as a period of carry unwind doesn't last forever - but in the short run, for a couple of weeks, investors would be feeling the heat," she noted.
U.S. stocks were broadly lower on Tuesday as trading resumed following the Labor Day holiday. The Dow Jones Industrial Average DJIA was slumping 1%, while the S&P 500 SPX was down more than 0.3% and the Nasdaq Composite COMP was off nearly 0.2%, according to FactSet data.
Still, in the view of Eric Wallerstein, chief market strategist at Clocktower Group, any systemic unwind of the yen carry trade looks unlikely this time, because traders mostly already braced for additional yen strength this year. That makes any further sudden yen strengthening less likely to catch traders off guard, he said, which could be enough to avoid a major panic-driven unwind.
"The carry trade is still a thing, and it will be as long as Japanese rates are much lower than the rest of the world," Wallerstein told MarketWatch via phone. "But the yen would have to strengthen materially and surprisingly in order for the eruptions that happened a couple years ago to re-materialize."
The ICE U.S. Dollar Index DXY, a gauge of the greenback's strength against a basket of major currencies including the Japanese yen, was off 0.3% on Tuesday, according to FactSet data.
During the carry-trade unwind in the summer of 2024, the yen strengthened by 13% against the dollar in two months. This time around, since the dollar-yen rate peaked in late July, it has dropped by less than 6%.
-Isabel Wang
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