The Yen carry trade: Approaching a tipping point?

Key takeaways

Rising repatriation risk: Higher Japanese Government Bond (JGB) yields are making domestic bonds more attractive relative to overseas assets, increasing the likelihood that Japanese investors bring capital back home.

BoJ rate hikes could accelerate the unwind: Markets may be underestimating the pace of Bank of Japan (BoJ) policy normalisation, with further rate increases potentially reducing the appeal of the Yen carry trade.

Supportive backdrop for Japanese assets: A stronger Yen, higher domestic yields, and increasing domestic investment flows could benefit selected Japanese equities and parts of the Japanese bond market.

We have long argued that the Yen carry trade is vulnerable to an unwind, including the risk of a disorderly adjustment. So far, that has not happened: Japan Government Bond (JGB) yields have continued to rise, while the Yen has weakened to its lowest level since 1986.

Fiscal channel: higher JGB yields reduce the appeal of foreign bonds

Higher JGB yields are reducing the relative appeal of foreign bonds for Japanese investors. The 30-year US Treasury (UST) - JGB spread has narrowed to around 120bps, while the 10-year spread is now about 180bps, versus roughly 360bps at the start of 2025. Some financial institutions argue that, on a hedged basis, a 10-year UST now yields less than a comparable JGB.

The Yen and US-Japan 10y interest rate differentials

Source: Bloomberg, W1M

Recent policy signals add to the repatriation risk. Japan’s finance minister has encouraged major pension funds, including the Y300tr (U$1.9tr) Government Pension Investment Fund (GPIF) to allocate more capital domestically. Even a low-single-digit allocation shift could generate hundreds of billions of dollars in flows.

Monetary policy: markets may still be too dovish on the BoJ

The second potential catalyst is increasing Bank of Japan (BoJ) policy normalisation. In June, PPI rose 7.1% year-on-year, its fastest pace in three years. Nominal wages have increased by 3% for four consecutive months, the longest such streak since 1992, while this year’s Japanese labour unions’ (Shunto) negotiations delivered wage gains of approximately 5%.

Against this backdrop, market pricing still looks too dovish. Investors are assigning only around a two-third probability to a BoJ rate hike by December, which appears far too low based on our recent one-on-one C-suite meetings with Japan’s leading financial groups. If producer-price and wage pressures feed through more broadly into CPI, a December hike is almost a given, followed by two further hikes in 2027 and another in 1Q 2028, taking the short-term policy rate to 2% from 1% currently.

This matters for the carry trade because its appeal depends on carry-to-volatility - the interest-rate differential relative to FX volatility. A narrower rate differential, combined with the potential for higher Yen volatility, reduces the attractiveness of the trade. Crowded positioning would amplify the risk of any unwind.

Commodity Futures Trading Commission (CFTC) data show net speculative Yen shorts of around 124,000 contracts, close to levels seen ahead of the 2024 Yen rally. This leaves the market exposed to upside data surprises or a sharp shift in sentiment.

Why it matters beyond Japan

Bottom line

A disorderly unwind is in no one’s interest. The key question is whether fiscal concerns continue to weigh on the Yen, or whether higher domestic yields and BoJ normalisation begin to draw Japanese capital back home. Conversations with insurance companies, pension funds and other financial institutions suggest the latter.

The main indicators to monitor are the Ministry of Finance (MoF) flow data for signs of repatriation, the Japan Securities Dealer Association (JSDA) data on domestic bond purchases, shifts in pension allocation and evidence that inflation is broadening. If these signals align, the case for Yen appreciation will become stronger.

Against this backdrop, an overweight position in Japanese equities remains an essential allocation in investor portfolios. We approach our equity exposure from a bottom up basis following 4 criteria – 1) a company needs to have a long term sustainable competitive advantage, 2) the ability to grow future free-cash-flow (FCF), 3) management incentive needs to be aligned with shareholders and stakeholders and 4) valuations need to be attractive relative to opportunity and risk. One of our holdings in the context of these criteria as well as further interest rate increases by the BoJ is Sumitomo Mitsui Financial Group (SMFG).

Within fixed income, while we continue to expect Japanese interest rates to move higher over time, we have recently reduced our short exposure to JGBs by adding selective long-end exposure within the bond funds. As hedged yields become more attractive and policymakers encourage greater domestic investment from institutions such as the GPIF, we believe the premium available on the longest-dated bonds is becoming increasingly compelling.

Glossary

Yen carry trade: An investment strategy where investors borrow in low-interest-rate Japanese Yen and invest in higher-yielding assets elsewhere to profit from the interest rate differential.

Policy normalisation: The process of moving interest rates and monetary policy settings back towards more typical levels following a prolonged period of exceptionally loose monetary policy.

Carry-to-volatility: A measure of the potential return from an interest-rate differential relative to the risk of exchange-rate fluctuations. A lower ratio generally makes carry trades less attractive.

Government Pension Investment Fund (GPIF): Japan’s public pension fund and one of the world’s largest institutional investors, whose asset allocation decisions can influence global capital flows.

Repatriation: The return of capital to an investor’s domestic market, often driven by improving local investment opportunities or changing policy and market conditions.