By Ella Yerushalmi
It goes without saying that financial markets have always experienced volatility. From the earliest forms of the bartering system, to our modern global financial network, investments are riddled with risk, in order to receive a greater reward. In recent times, with conflict with Iran and geopolitical instability, artificial intelligence impacting tech stocks and the wider interconnectedness of the world, financial systems have become increasingly unstable. Therefore, it comes as no surprise that in recent months there has been renewed attention to a longstanding hedge fund strategy called a carry trade.
In a carry trade, traders borrow at a low interest rate and then invest in assets with a higher return, earning profit from the difference, or the “carry.” For nearly 30 years, starting in the mid ‘90s, the Japanese bond market had near 0% rates. Japanese traders would borrow yen, then convert it into USD and invest in United States bonds with 3-4% rates. The spread between these low borrowing costs and higher U.S. yields allowed for predictable returns, especially when bought with debt or leverage. Traditionally, American bonds are very stable, making this a relatively simple way to earn predictable capital.
However, this strategy always came with long-term risk: any sort of market volatility can wipe out years of profit. Now, the Japanese bond market’s interest rate is rising. Currently, the 10-year Japanese Government Bond (JGB) yield hovers at around 2.2%, far from the 0% it once was. This means that borrowing in yen is no longer essentially free. Japanese investors can now earn more domestically, reducing the incentive to hold foreign bonds. The Bank of Japan (BOJ), Japan’s central bank (think the U.S. Federal Reserve), has introduced a gradual normalization of monetary policy. The BOJ is looking to combat Japan’s inflation rates, especially with a new prime minister in office. The current Japanese government’s plan deviates from decades of ultra-loose policies, with negative interest rates. To stimulate growth, Japan is printing more money, cutting taxes and spending aggressively (with promises to raise the defense budget to 2% GDP). In January 2026, the interest rate was raised to 0.75%, and additional hikes are being signaled for March. All of this forces Japanese hedge funds to sell U.S. bonds and close leveraged carry positions.
According to the new government policy, Japan now needs to reduce its holdings of foreign bonds, which totals hundreds of billions of dollars. For context, the carry trade was estimated to reach a high of $1 to 1.5 trillion at its peak in 2021-2022 before declining to perhaps $500 billion. The carry trade, which still occurs at reduced levels, can still have a meaningful impact because of its global scale.
Still, Japan is historically one of the largest foreign holders of U.S. government debt. BOJ normalization could trigger the largest global deleveraging since 2008. Now that they have the potential to leave U.S. bonds behind, the question arises of who will buy American bonds going forward.
This situation is having a serious ripple effect on the markets. We have seen these effects on U.S. markets, as the Japanese yen price recently reached high currency volatility. There are a few scenarios that could play out. The first is a significant dumping of U.S. bonds, which will mean the Federal Reserve will have to print more money through Quantitative Easing (QE), cut rates and then purchase the Treasuries directly. To protect against this possibility, it’s important to hedge with anti-inflationary assets of your choosing or diversify with foreign markets.
Another possible situation is the U.S. going into a recession or depression, where people will drive to bonds in a “flight to safety” scenario. In that case, demand for Treasuries would rise organically, pushing yields lower despite foreign selling. Perhaps in a best-case scenario, there will be a gradual rebalancing, with positions over time changing.
Many believe that all the talk of the yen carry trade unwind is simply the latest fad topic, one that as of late has been grossly overmentioned. Even with all the attention, the yen carry trade unwind is unlikely to destabilize Treasuries because most institutional positions are currency-hedged. Markets often cycle through narratives. The real question is whether this is a temporary positioning adjustment or the beginning of a structural shift in global capital flows. The carry trade is clearly shrinking, but the more important factor is how global markets will adapt.
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