BOJ's Cautious Hike Slows Yen's Appreciation, But Carry Trade Risk Remains

The Bank of Japan's recent interest rate hike has sparked concerns about a potential reversal of the yen carry trade, which was at the center of a broad sell-off in global assets in 2024. The market had expected more aggressive tightening from the BOJ, but its cautious approach and slower pace of hikes have limited the impact on global markets.

The yen's appreciation has slowed down due to the BOJ's gradual hike pace and the Federal Reserve's policy cycle, which has capped the narrowing of the US-Japan yield differential. This has curbed the yen's one-way rapid appreciation momentum.

However, market concerns about a reversal of the yen carry trade have not been entirely alleviated. The risk of a sudden, concentrated reversal remains, particularly if there is a decline in USD asset prices or a sharp pullback in US equities.

The yen carry trade is driven by the interplay of three key components: the funding leg, the exchange rate leg, and the asset leg. On the funding leg, low-interest yen are borrowed at financing costs determined by the BOJ's policy rate. On the exchange rate leg, the borrowed yen are converted into USD, where exchange rate fluctuations directly impact principal conversion gains/losses.

Currently, while certain marginal changes have emerged across the three legs, the catalytic conditions triggering a full-scale, stampede-style unwinding of carry trades have not yet materialized. The BOJ's overall stance remains cautious, and it is unlikely to quickly raise yen funding costs due to fundamental constraints and fiscal limitations within Japan.

The core profit of carry positions stems from the US-Japan yield spread, which remains elevated at around 200 bps. This will not rapidly erode the profitability of carry trades in the short term, giving traders time to adjust leverage and gradually reduce positions.