Japan's government bond yields hit 30-year highs, global markets face risk of unwinding "yen carry trades"

Original Author: Long Yue

Original Source: Wall Street CN

Japan's 10-year government bond yield broke above 3% this week, hitting a nearly 30-year high, and the ripple effects are beginning to spread globally.

This breach of a key threshold, combined with a persistently weakening yen and rising expectations of Bank of Japan rate hikes, has sharply intensified market concerns over a large-scale unwind of "yen carry trades." U.S. Treasury Secretary Bessent has publicly warned that disorderly moves in the yen market could trigger forced liquidations, roiling global markets and ultimately pushing up borrowing costs for American households and businesses.

Markets have 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 signaled early this year.

Why Did Yields Break Above 3% Now?

Japan's 10-year government bond yield rose above 3% on Tuesday for 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 from major central banks. But traders and economists say Japan's situation deserves particular attention.

The Bank of Japan has ended decades of ultra-loose policy, and markets broadly expect its key policy rate to be hiked further from the current 1% level. Meanwhile, continued yen weakness and rising inflation have added further pressure on the central bank to accelerate its tightening pace.

Policy dynamics are also adding pressure. U.S. Treasury Secretary Bessent has explicitly stated he expects BOJ Governor Kazuo Ueda to hike rates as early as this month. Meanwhile, Prime Minister Sanae Takaichi's administration has openly leaned toward expanding fiscal stimulus, raising investor concerns about Japan's fiscal sustainability—part of the reason behind both yen weakness and rising bond yields.

Carry Trades: How Large Is the Scale, How High Is the Risk?

The logic of the "yen carry trade" is simple and direct: borrow low-yielding yen, buy higher-yielding assets.

This strategy flourished during Japan's prolonged period of ultra-low interest rates. Two years ago, when the BOJ raised its policy rate to 0.25%, markets experienced severe turbulence, widely attributed to a sudden unwind of carry trades.

According to the Financial Times, analysts note that the accumulation of carry trade positions since 2024 has been substantial. Osamu Takashima, a forex strategist at Citi, noted: "Hedge funds and other short-term investors have been shorting the yen against the dollar while going long high-yielding currencies such as the Mexican peso."

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

The latest Bank of America Global Fund Manager Survey shows that "short yen" remains one of the three most popular trades globally.

That said, most analysts believe the risk of a large-scale, sudden unwind of carry trades remains manageable for now. Kamakshya Trivedi, chief FX strategist at Goldman Sachs, said yen-funded carry trades this year have proven more resilient than during the 2024 intervention period, and that a "structural unwind" would require Japanese investors to repatriate funds from overseas assets on a large scale. He added: "At this point, there is almost no sign in official portfolio flow data that such a rotation has occurred."

James Lord, global head of FX strategy at Morgan Stanley, also noted that Japanese investors are still "buying U.S. assets heavily" and that "we have not yet seen a significant rotation by Japanese investors back into local assets."

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, markets worry that Japan's major pension funds and life insurers—institutions that have accumulated tens of billions of dollars in paper losses on bond holdings—may adjust investment strategies and rotate funds from overseas back home.

Naka Matsuzawa, rates strategist at Nomura, said Thursday's 30-year Japanese government bond auction will be a key signal for whether this trend has already begun. "If life insurers participate actively in the auction, it could easily trigger market speculation that some funds are flowing back from overseas into Japanese assets."

Citi's Takashima noted that life insurers have been waiting for 20-year JGB yields to rise to 2.5%-3% but have yet to enter the market in force because they fear prices could fall further. "If they believe the downside risk is capped, we could see larger capital flows."

BOJ: September Hike Nearly a Done Deal, Another Move in October?

Markets have 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 signaled early this year.

Economists believe the BOJ's rate hike is partly aimed at coordinating with the government's broader efforts to support the yen.

More notably, some are beginning to bet on another hike as early as October. Hajime Takata, a hawkish member of the BOJ's policy board, said in a speech on Wednesday that a 25-basis-point hike is "not a foregone conclusion" and emphasized that "the environment has changed." Kazuo Ueda said the same day that the BOJ would discuss interest rates at all future meetings.

Despite all this, the yen remains weak, hovering near 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 already been given back. Analysts partly attribute the persistent yen weakness to rising equities—foreign equity investors typically hedge exposure by shorting the yen, and are forced to add to short positions when stocks rally.