Japan's 10-Year Yield Hits 30-Year High, Raising Global Unwinding Risks for Yen Carry Trades

Original author: Long Yue

Original source: Wallstreetcn

Japan's 10-year government bond yield broke above 3% this week, hitting a near 30-year high, and the resulting chain reaction is spreading globally.

The breach of this key threshold, combined with the yen's continued weakness and rising expectations of Bank of Japan rate hikes, has sharply heightened market concerns about a large-scale unwinding of yen carry trades. U.S. Treasury Secretary Scott Bessent has publicly warned that disorderly movements in the yen market could trigger forced liquidations, impacting global markets and ultimately raising borrowing costs for American households and businesses.

Currently, the market has fully priced in a 25-basis-point rate hike by the Bank of Japan in September—a pace far more aggressive than the central bank hinted at the start of the year.

Why did the yield break 3% now?

Japan's 10-year government bond yield rose above 3% on Tuesday, the first time since September 1996.

This move is not an isolated event. Global bond markets are broadly under pressure as investors recalibrate inflation expectations and anticipate further rate hikes by major central banks. But traders and economists believe Japan's situation is particularly noteworthy.

The Bank of Japan has ended decades of ultra-loose policy, and the market widely expects its main policy rate to continue rising from the current 1% level. At the same time, the yen's persistent weakness and ongoing inflationary pressures are adding to the pressure on the central bank to accelerate rate hikes.

Policy is also adding pressure. U.S. Treasury Secretary Scott Bessent has explicitly stated he expects Bank of Japan Governor Kazuo Ueda to raise rates as early as this month. Meanwhile, the government of Japanese Prime Minister Sanae Takaichi has openly favored expanding fiscal stimulus, which has raised investor concerns about Japan's fiscal stability and is part of the reason for the yen's weakness and rising bond yields.

Carry trades: How big and how risky?

The logic of the yen carry trade is simple and direct: borrow low-interest yen and buy high-yield assets.

This strategy flourished during Japan's prolonged period of ultra-low interest rates. Two years ago, when the Bank of Japan raised its policy rate to 0.25%, markets experienced severe turmoil, which was attributed to the sudden unwinding of carry trades.

According to the Financial Times, analysts note that the accumulation of carry trade positions since 2024 has been substantial. Citigroup FX analyst Osamu Takashima pointed out: "Hedge funds and other short-term investors have been shorting the yen against the dollar while going long high-yield currencies like the Mexican peso."

Analysts at Capital Economics, citing data, said that in early August this year, outstanding loans by Japanese residents to overseas borrowers exceeded the 2024 peak; loans from Tokyo branches of non-Japanese banks to their headquarters also reached the highest level since the global financial crisis.

Bank of America's latest global fund manager survey shows that "short yen" remains one of the three most popular trades globally.

However, most analysts believe the risk of a large-scale, sudden unwinding of carry trades is still manageable for now. Goldman Sachs chief FX strategist Kamakshya Trivedi said that yen-funded carry trades this year are more resilient than during the 2024 intervention period, and a "structural unwinding" would require Japanese investors to repatriate funds from overseas assets on a large scale. He added: "Currently, there is little sign in official portfolio flow data that such rotation has begun."

Morgan Stanley's global head of FX strategy, James Lord, also said Japanese investors are still "buying heavily" into U.S. assets, "We have not yet seen a significant shift by Japanese investors back into local assets."

U.S. Treasuries and global markets: Japan is the largest foreign holder

Japan is the largest foreign holder of U.S. Treasuries, with holdings exceeding $1 trillion, most of which are held by financial institutions.

As domestic yields rise, there are concerns that large Japanese pension funds and life insurers—which have accumulated tens of billions of dollars in unrealized losses on their bond holdings—may adjust their investment strategies and shift funds from overseas back home.

Nomura rates strategist Naka Matsuzawa said Thursday's auction of 30-year Japanese government bonds will be an important signal of whether this trend has begun. "If life insurers actively participate in the bond auction, it could easily spark market speculation that some funds are flowing back from overseas to Japanese assets."

Citigroup's Takashima noted that life insurers have been waiting for 20-year JGB yields to rise to 2.5% to 3%, but have not yet entered the market on a large scale because they worry prices could fall further. "If they believe the downside risk has been capped, we could see larger fund flows."

Bank of Japan: September hike almost certain, another in October?

The market has now fully priced in a 25-basis-point rate hike by the Bank of Japan in September, a pace far more aggressive than the central bank hinted at the start of the year.

Economists believe this rate hike is partly intended to support the Japanese government's overall efforts to shore up the yen.

More notably, some are beginning to bet on another hike in October. Hajime Takata, a hawkish member of the Bank of Japan's policy board, said in a speech on Wednesday that a 25-basis-point hike is "not set in stone" and stressed that "the environment has changed." On the same day, Kazuo Ueda said the Bank of Japan will discuss interest rates at all future meetings.

Despite this, the yen remains weak, hovering around 160 yen per dollar. Joint intervention by Japanese and U.S. authorities in July and August sharply boosted the yen, but more than half of those gains have been retraced. Analysts partly attribute the yen's persistent weakness to rising stock markets—foreign equity investors typically hedge their exposure by shorting the yen, and are forced to increase short positions when stocks rise.