The Japanese yen has fallen below 158 against the U.S. dollar after traders reduced expectations for another Bank of Japan rate hike in October.
The weaker yen is keeping yen-funded carry trades attractive for now, but a sudden reversal could create problems for leveraged investors and spill into global markets, including Bitcoin and other cryptocurrencies.
The yen dropped as much as 0.5% to 158.21 per dollar on October 1 after the BOJ released a summary of opinions from its September meeting.
Traders had been looking for stronger signals that the central bank was preparing to raise rates again this month. Instead, market pricing for an October 30 rate hike fell below 20%, compared with more than 30% the previous day. A rate increase by December remained fully priced.
A weaker yen does not mean carry trades are being closed. In fact, it can make the strategy more attractive because investors can borrow yen at relatively low rates and invest the money in higher-yielding currencies and assets.
The bigger risk comes if the yen suddenly starts gaining strength.
Japan has long been an important source of cheap funding for global investors. Traders can borrow yen and use the money to buy assets that offer higher returns elsewhere.
That trade is becoming more complicated as the BOJ moves away from its long period of very low interest rates.
Japan’s 10-year government bond yield recently reached 3.075%, its highest level since 1996. Higher Japanese yields can make domestic investments more attractive and reduce the incentive to borrow yen and invest overseas.
For now, however, the carry trade has not seen a major disorderly unwind. The yen weakened after the latest BOJ decision and has now moved beyond 158 per dollar, leaving a large interest-rate gap between Japan and the United States.
The BOJ is still considering further rate increases. Its September meeting summary showed that several policymakers supported higher borrowing costs. One member said the bank may need to speed up rate hikes if inflation moves above expectations.
Another policymaker said moving the policy rate closer to its target relatively soon could give the BOJ more room to respond to changes in the economy.
At the same time, two members opposed the September rate hike, while other policymakers pointed to weak consumer spending and slower services inflation as reasons to move carefully.
The yen also faces another major risk: currency intervention.
Japan and the United States carried out a rare coordinated intervention on July 31 after the yen had fallen close to 40-year lows. Japanese officials have continued warning markets that authorities are watching the currency closely.
A sudden intervention could quickly change the carry trade. Investors who borrowed yen would face higher repayment costs if the currency strengthened sharply. Leveraged traders could then be forced to sell assets and buy yen to close their positions.
If many investors do this at the same time, the process can accelerate. Rising yen prices can put more pressure on other carry traders, leading to additional position closures.
Markets experienced a similar situation during the August 2024 selloff.
The Bank for International Settlements later estimated that carry trade exposure around that period may have been roughly ¥40 trillion, or about $250 billion at the time, although it warned that limited data could mean the actual amount was larger.
The 2024 unwind also affected crypto markets. Bitcoin fell to around $49,000 during the turmoil, while the total crypto market capitalization dropped from about $2.16 trillion to $1.78 trillion.
The connection does not require investors to have directly borrowed yen to buy Bitcoin. When carry trades come under pressure, leveraged investors may sell liquid assets to raise cash, meet margin requirements or repay yen-denominated debt.
Crypto markets can react especially quickly because Bitcoin, Ethereum and other major cryptocurrencies trade around the clock.
Similar concerns have returned as Japan continues moving toward higher interest rates. Bitcoin has experienced sharp moves around previous BOJ decisions, although those price changes alone do not prove that yen carry trade liquidation caused them.
The current situation is different from a full carry trade unwind because the yen is still weakening rather than strengthening.
With USD/JPY above 158, investors borrowing yen are not yet facing the currency shock that can force large numbers of positions to close. Lower expectations for an October BOJ hike have also reduced immediate pressure on borrowing costs.
However, Japanese bond yields are continuing to rise. Higher long-term yields could gradually make Japanese assets more attractive and reduce the appeal of keeping money invested overseas.
Japan’s latest Tankan survey also gave the BOJ some reason to avoid rushing into another rate increase. Confidence among large manufacturers reached its highest level in more than eight years, while the survey showed limited signs of accelerating inflation pressure.
For yen-funded traders, the main risks now are a stronger yen caused by intervention or a faster-than-expected shift toward higher BOJ interest rates.
If either happens, leveraged carry positions could come under pressure quickly. Because crypto is one of the more liquid and continuously traded risk markets, Bitcoin and other digital assets could also feel the impact if investors begin reducing leverage across global markets.
