Once the US economy weakens beyond expectations, the asset side will trigger a concentrated unwinding of carry trades.

Written by: Wu Shuo, Lin Yan, Wall Street Insights

In September, the central bank raised interest rates as expected, but the intensity was not as aggressive as the market had previously anticipated, which gave the market a brief "breath." Previously, the yen had rapidly appreciated, combined with a series of "hawkish" signals from Japanese central bank officials, leading the market to once again think of the reversal of carry trade in 2024—at that time, global assets faced widespread selling, leaving a profound "shadow" on the market, causing the market to be apprehensive about this round of Japanese central bank interest rate hikes.

However, the Japanese central bank is not as "hawkish" as previously expected by the market. Although Ueda Kazuo did not rule out the possibility of continuous rate hikes in the post-meeting press conference, there remains an absence of clear guidance on the pace of rate hikes. Coupled with the absence of significant negative external factors (US August non-farm data showed robust performance, and oil prices declined), the impact of this rate hike on global markets is limited, with Asia-Pacific stock markets broadly rising, and the yen further weakening after the rate hike was realized.

However, market concerns have not completely disappeared. As the Bank of Japan continues to advance its rate hike process, the financing cost of the yen is rising, gradually reducing the yen's appeal as a funding currency for global carry trades. However, we believe that the risk of a concentrated reversal in yen carry trades in the short term has eased, with funds likely showing more signs of a slow return, making the overall spillover impact controllable.

Essentially, the yen carry trade is driven by the linkage of three major aspects: financing side, exchange rate side, and asset side: financing side, borrowing low-interest yen, with the funding cost determined by the Bank of Japan's policy rate; exchange rate side, converting borrowed yen into dollars, where exchange rate fluctuations directly affect the profit and loss of currency conversion; asset side, using dollars to allocate high-yield assets such as US Treasuries and US stocks, earning interest rate spreads and capital gains from the asset side.

Therefore, a large-scale stampede-like reversal of carry trades often requires the resonance of three conditions: continuous rate hikes in Japan pushing up yen financing costs, rapid and significant appreciation of the yen leading to currency conversion losses, and falling prices of dollar-denominated assets compressing profit space.

Currently, while there have been certain marginal changes in the three components, the catalytic conditions triggering a comprehensive stampede-like unwinding have not yet formed:

On the financing side, although the Bank of Japan has initiated rate hikes, its overall stance remains cautious, and it will not rapidly raise yen financing rates. Current fundamental constraints and fiscal limitations within Japan are unavoidable issues for the Bank of Japan, which underscores its lack of foundation for rapid and large-scale rate hikes (this point is even more evident compared to the United States).

The core yield from carry positions comes from the interest rate differential between the US and Japan. Although the attractiveness of yen financing is diminishing, the interest rate differential remains relatively high (the 10-year differential is still around 200 basis points), which will not rapidly erode the profit space of carry trades in the short term, allowing traders time to adjust leverage and gradually reduce positions, making concentrated passive unwinding unlikely.

On the exchange rate side, what is important is not only the level of the yen but also its appreciation speed. Only with a rapid short-term surge in the yen can significant unrealized currency losses arise quickly, forcing traders to concentrate their unwinding; if the yen strengthens slowly, the market will have plenty of time to adjust positions, making it less likely to trigger a stampede.

Currently, the rate of yen appreciation has slowed: on one hand, due to fundamental constraints, the Bank of Japan's rate hike pace may not be too fast; on the other hand, this round of rate hikes by the Bank of Japan resonates with the Federal Reserve's policy cycle, which somewhat limits the narrowing of the US-Japan interest rate differential and restrains the momentum of the yen's rapid unilateral appreciation.

On the asset side, the core depends on global risk appetite and the performance of dollar asset yields. Carry trade funds ultimately flow into dollar-denominated assets such as US Treasuries and US stocks, making the asset side the source of carry trade profits. Once US stocks undergo a significant pullback and US Treasury yields decline rapidly, the returns from the asset side shrink or even incur losses, compounded by rising yen financing costs and the currency conversion losses from yen appreciation, the triad of pressures can easily trigger large-scale unwinding.

Currently, US stocks and other high-yield dollar assets remain resilient overall, and the macro environment and AI terminal demand have not yet shown signs of systematic deterioration, allowing asset side returns to still cover yen financing and currency conversion costs, with a lack of strong catalysts for concentrated exits.

In summary, looking ahead, the pace of the Bank of Japan's rate hikes is cautious, the yen lacks a basis for unilateral rapid ascent, and there are no systemic signals of a significant drop in overseas assets, making it unlikely to replicate the violent unwinding of carry trades experienced in 2024 in the short term.

Moreover, the current overcrowding of yen depreciation trades has significantly decreased. Since the US-Japan joint intervention, yen shorts have noticeably been covered, and as of the week ending September 15, the CME non-commercial yen short positions have decreased by about 56% from the late July peak, while long positions have surged by 135%, and net long positions since September have also moved out of negative territory. Considering that some yen shorts have already taken steps to cover early, the risks of subsequent rapid covering triggering a concentrated unwinding of carry trades are relatively controllable.

Whether carry trades will face concentrated reversal risks in the future needs close monitoring: the pace and magnitude of Japanese central bank rate hikes exceeding expectations, as well as the speed and slope of the yen's short-term appreciation. But the most critical factor is that asset side risks are the most core catalyst for triggering concentrated unwinding of carry trades.

This can also be learned from the experience of the carry trade reversal in 2024. At that time, the market faced an environment of rapid yen appreciation and the Bank of Japan initiating interest rate hikes, but the final blow to carry positions came from the asset-side shock brought about by corrections in global risk assets. In 2024, initially, the simple rise in yen interest rates and yen appreciation only triggered gradual adjustments in positions; only when the US unemployment rate rose in August triggering the Sam Rule and heightening recession expectations did a systemic sell-off of global assets occur, accelerating the concentrated unwinding of carry trades and the yen's appreciation trend.

Therefore, we need to remain vigilant about the potential tail risks in US assets that could accelerate the reversal of carry trades. Key factors to observe include the continued unexpected weakening of the US economy, intensifying geopolitical conflicts, increasing divergences in the AI sector, and severe fluctuations in the US Treasury market, which may increase the risk of concentrated unwinding in the short-term carry trades.