[Financial Planning for the 100-Year Life] Possibility of Yen Carry Trade Unwinding: The Biggest Risk in Global Financial Markets

The biggest risk in the global financial markets at the end of the year and the beginning of the next is likely to be the potential unwinding of the yen carry trade. Even if the probability is not high, the impact on global financial markets would be significant, so careful attention is required.

The yen carry trade is a strategy that involves borrowing yen at low interest rates and investing in high-yield assets. However, when investor sentiment falters, a sudden and massive unwinding can occur. The fact that almost every major market upheaval-such as the 1998 Long-Term Capital Management (LTCM) crisis, the 2008 financial crisis, the 2011 Great East Japan Earthquake, the 2015-2016 slowdown in China’s economy, and the early days of the COVID-19 pandemic in 2020-was accompanied by a sharp surge in the yen and the unwinding of the yen carry trade demonstrates this clearly.

Recently, the macroeconomic environment has begun to resemble past periods of unwinding. The Bank of Japan (BOJ) has declared an end to more than 20 years of deflation and has entered a phase of interest rate normalization. The benchmark interest rate, which was negative from 2016 to 2023, turned positive in 2024. The BOJ is highly likely to raise the benchmark rate from 0.50% to 0.75% at its upcoming monetary policy meeting on the 18th and 19th, and the trend of rate hikes is expected to continue into 2026. If the wage increase rate at the 2026 spring labor negotiations exceeds 3%, the BOJ could raise rates faster than expected. The rise in Japanese interest rates is not merely a change in Japan’s monetary policy; it is a structural shift that fundamentally undermines the yield basis of the yen carry trade. If the US Federal Reserve lowers its benchmark rate, the interest rate gap between the US and Japan will narrow further, which would be a classic trigger for the collapse of the yen carry trade.

Once the unwinding begins, global financial markets experience a chain reaction. The first reaction is a sharp appreciation of the yen. The yen is the world’s fastest-rising currency in risk-off situations. Carry trade investors buy back the borrowed yen to unwind their positions, triggering short covering and further strengthening the yen. This appreciation of the yen further erodes investor sentiment and leads to full-scale global financial market instability.

The second reaction is a simultaneous decline in emerging market assets. Yen carry trade funds are widely invested in emerging market stocks and bonds, commodities, and high-risk investment assets. Therefore, when unwinding begins, emerging markets become the most vulnerable link. As foreign capital outflows accelerate, emerging market currencies weaken, stock prices plunge, and bond yields rise all at once. Markets with high export dependence, such as South Korea and Taiwan, could be hit especially hard.

The third reaction is a tightening of the bond and global liquidity markets. As the preference for safe assets increases, US Treasury yields fall, but corporate credit spreads widen. The cost of raising dollars and yen also surges. This accelerates deleveraging among highly leveraged hedge funds and trend-following funds (CTAs), driving up risk premiums.

So what signals should investors watch for? There are several “early warning indicators” for the unwinding of the yen carry trade. First, the speed of the yen’s appreciation: a daily surge of 2-3% can be interpreted as a signal of carry trade unwinding. Second, rising Japanese market interest rates and hints of policy changes from the BOJ: Japan’s 10-year government bond yield recently hit 1.95%, the highest since 2007, which is a direct factor undermining structural carry yields. Third, a sharp increase in global risk indicators such as the VIX and CDS. Fourth, a rapid decline in emerging market currencies, which signals a quick withdrawal of carry trade funds. Fifth, data on net short positions in the yen: if the yen moves while net shorts are excessive, there can be an explosive unwinding of positions in the opposite direction.

Since Prime Minister Sanae Takaichi took office, the value of the yen has declined and the yen carry trade has expanded further. However, with Japanese interest rate normalization, a narrowing US-Japan interest rate gap, debates over an artificial intelligence (AI) investment bubble, concerns about dollar liquidity, and a slowdown in China’s economy all coinciding, the structural risk of a yen carry trade unwinding is increasing. As past cases have shown, the unwinding of the yen carry trade is not just a foreign exchange event, but a major shock that shakes the entire global financial market. It is essential to closely monitor the warning signals for unwinding, focus on risk management first, and then actively seize the opportunities that follow.

Kim Youngik, Director of the Tomorrow Hope Economic Research Institute

This content was produced with the assistance of AI translation services.