Borrow cheap yen, invest in higher-yielding assets, pocket the spread: repeat with leverage.
That simple idea, known as the yen carry trade, has fueled enormous profits for hedge funds and global investors for decades.
But when market conditions shift, this strategy unravels spectacularly, wiping out positions and triggering cascading selloffs across global markets.
Today, with the Bank of Japan hinting at raising rates and the interest-rate gap narrowing, the trade is far less carefree than it was a year ago.
What the yen carry trade actually is
Here’s how it works in plain English. Japanese interest rates have hovered near zero for years, while US rates sit around 4.2%, a massive spread.
A trader borrows ¥100 million at 0.5% and converts it to dollars. They invest those dollars in US Treasury bonds yielding 4.2%.
The difference: roughly 3.7% is the profit, minus hedging costs. Scale this up with leverage, and modest rate spreads become real money.
Annualized returns on dollar-yen carry trades typically hover between 5% and 6%. In 2025, with USD/JPY trading around 156 yen per dollar, the trade remains profitable but increasingly fragile.
The strategy has attracted hedge funds, banks, and even Japanese retail traders betting the yen stays weak or stable.
But it’s built on a dangerous assumption: that interest rates stay where they are and currency markets don’t move sharply. When that assumption breaks, everything implodes.
How traders turn tiny rate gaps into big returns, and losses
The magic is leverage. Suppose a trader borrows $10 million in yen at 0.5% to buy US bonds yielding 4%.
The raw spread of 3.5% earns $350,000 annually: solid, but not earth-shattering. Add five-to-one leverage, and that $350,000 becomes $1.75 million.
Double it again, and suddenly the carry trade looks irresistible.
But leverage cuts both ways. If the yen appreciates just 2% against the dollar, a leveraged position loses money fast.
In August 2024, when the Bank of Japan surprised markets by raising rates from 0.1% to 0.25%, the yen surged 6% in a week.
Traders holding heavily leveraged carry positions faced margin calls, demands to post fresh collateral, or liquidate positions immediately.
The ensuing forced selling spread panic through stocks, bonds, and currencies. The VIX, a measure of market fear, spiked to 65, levels normally reserved for financial crises, despite no underlying economic collapse.
When the carry trade goes wrong
Three warning signs suggest danger ahead. First, watch USD/JPY. If the exchange rate falls sharply, meaning the yen strengthens, carry trades face immediate losses.
Second, monitor the interest-rate gap. As of November 2025, the gap has narrowed to roughly 3.7% from historical highs above 5%, reducing the profit margin. Even a 0.3–0.5% yen move can erase months of gains.
Third, track BoJ signals. Governor Ueda has signaled a gradual path to rate hikes if inflation stays near 2.7%. Tighter policy ahead means a smaller carry-trade spread and more borrowing costs.
Watch these checkpoints: USD/JPY exchange rate, the BoJ policy meeting calendar, US-Japan interest-rate differentials, and the VIX. When VIX spikes above 40, leverage-heavy positions typically crack.
The yen carry trade can be a steady earner in calm markets, until it isn’t.
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