The yen carry trade isn’t dying, it’s evolving

The first part is familiar. As Japan moves away from ultra-low interest rates, the yen carry trade will become less attractive.

This strategy involves borrowing cheaply in yen and investing the money in currencies and assets offering higher returns. I expect it to shrink gradually, not implode.

But the second could prove just as important. For decades, Japan has also supplied global markets with capital. As Japanese interest rates rise, more of that money may have reason to stay at home.

So the question isn’t just: what happens to the yen carry trade? It’s also: what happens when Japanese capital becomes less abundant overseas?

Replacing the yen isn’t easy

Investors are already considering alternative funding currencies, particularly the Swiss franc and Swedish krona. But I wonder how much of the adjustment they can absorb.

In 2025, average daily foreign-exchange turnover involving the yen was roughly US$1.6 trillion, compared with around US$612 billion for the Swiss franc. Turnover was smaller still for the krona. These figures measure currency-market activity, not carry trades, but they show the difference in market depth.

There is another complication. Diversifying the funding currency does not necessarily diversify the risk.

Both the yen and Swiss franc can strengthen during periods of financial stress. If investors borrow in both, a shock could still force leveraged positions to unwind together.

August 2024 showed how quickly this can happen. A change in expectations around Japanese monetary policy was followed by yen appreciation, forced deleveraging and losses in global equity markets.

For me, the key is not how far the yen moves, but how quickly. A gradual 5% move may be manageable. Compress the same move into a few trading sessions and investors may have to unwind positions quickly, amplifying the market impact.

My central view, therefore, is for gradual deleveraging punctuated by occasional sharp drawdowns, rather than one dramatic end to the strategy.

But the carry trade is only half the story

A slower change is happening at the same time.

As domestic yields rise and currency hedging becomes more expensive, Japanese institutional investors are reassessing their overseas bond allocations.

I expect any repatriation to be gradual. But even a slow reduction in Japanese demand for overseas bonds could put upward pressure on global borrowing costs.

That leaves markets facing two adjustments, at a time when global demand for capital may be outpacing supply.

One is cyclical and potentially violent: occasional carry-trade unwinds when the yen rises rapidly.

The other is structural: Japanese capital gradually becoming less abundant overseas.

For years, Japan’s importance to global markets has partly reflected its extraordinary supply of cheap money. Monetary normalisation is changing that relationship amid signs of market fragility everywhere you look.

Japan’s importance to global markets isn’t disappearing. It is changing form, and that adjustment may prove just as consequential.