"The Troublemaker" Yen Arbitrage Trading Makes a Comeback! Global Stock Markets Tremble

According to the Zhitong Finance APP, the "yen carry trade" that disrupted global financial markets in early August—a type of arbitrage investment strategy that surged astonishingly this year and severely impacted global stock markets due to the unwinding of trades—is once again being enthusiastically welcomed by speculative forces and some leveraged hedge funds. The yen carry trade, which once single-handedly disrupted the entire financial market, is showing signs of recovery, primarily due to the significant yield gap between Japanese and U.S. Treasury markets and the still relatively low volatility driving this low-cost currency arbitrage trading.

However, as the "yen carry trade" revives, it coincides with the possibility that the Bank of Japan may announce an interest rate hike in December and potentially release an unexpected hawkish monetary policy path, undoubtedly raising market concerns about the re-emergence of the "arbitrage trade unwinding storm," a nightmarish financial event that severely impacted global stock markets in early August.

According to forecasts and analysis reports based on statistics from the Japan Financial Futures Association, Tokyo Financial Exchange, and the U.S. Commodity Futures Trading Commission, Japanese retail investors, along with leveraged hedge funds from abroad and some foreign asset management companies, may significantly increase their bearish bets on the yen from $9.74 billion in October to $13.5 billion in November.

Analysts expect these bearish bets to continue to rise next year, primarily due to the enormous gap in benchmark interest rates and Treasury yields between Japan and the U.S., increased U.S. government borrowing, and relatively low volatility in the foreign exchange market. These conditions make borrowing in Japan at extremely low costs and then deploying funds to higher-yielding markets globally, such as the U.S. stock and bond markets, more attractive.

Speculative forces begin to re-establish short positions in the yen—monthly net positions in yen

Alvin Tan, head of Asian foreign exchange strategy at Royal Bank of Canada in Singapore, stated: "Compared to most currencies, the absolute interest rate differential of the yen is very large, which means the yen will always be viewed by the market as a funding currency. A sovereign currency is unlikely to be used as a funding currency for arbitrage trades mainly due to its lower volatility and interest rate differential."

Undercurrents in the financial market, a familiar sense of crisis is approaching!

Strategists at Mizuho Securities and Saxo Bank indicated that the scale of yen carry trades may rebound to the levels seen from late July to early August this year—but after that, the Bank of Japan suddenly announced an interest rate hike and released hawkish signals at the end of July, combined with weak non-farm payroll data at the time that heightened recession expectations in the U.S., leading to a sharp rise in the yen and investors suddenly exiting the carry trade, which severely impacted global stock markets.

Looking at the current financial market backdrop, one phenomenon to note is that Donald Trump's return to the White House may plunge the foreign exchange market into turbulent trading with significant volatility The widespread adoption of this investment strategy is very likely to impact the global stock market. The wave of global stock market sell-offs this summer was precisely due to the "unwinding of yen carry trades leading to a wave of liquidations." Under this turmoil, approximately $6.4 trillion was wiped off the global stock market in just three weeks, and the Japanese blue-chip benchmark, the Nikkei 225 index, experienced its largest decline since 1987.

Notably, the yen exchange rate surged last week, and the volatility in the foreign exchange market intensified following Trump's election victory. Coupled with the upcoming release of U.S. non-farm payroll data this week and the Bank of Japan's latest monetary policy decision to be announced in two weeks—expectations for a rate hike by the Bank of Japan in December have significantly increased recently—this macro environment and the undercurrents in trading can be said to be reminiscent of the global stock market sell-off in early August, highlighting the ongoing risks faced by investors who are re-engaging in this carry trade.

Bank of Japan Governor Kazuo Ueda recently stated that he is considering the timing of potential rate hikes and emphasized that the Bank of Japan will focus on wage levels and other price-related areas when deciding whether to raise rates. Recent economic data showed that inflation in Tokyo accelerated last month, exceeding expectations, and combined with Japan's resilient GDP and Ueda's hawkish remarks, this has rapidly fueled expectations for a rate hike by the Bank of Japan in December.

The forced large-scale liquidation of "carry trades" was the culprit behind the "Black Monday" of the global stock market in early August. At that time, the rapid appreciation of the yen prompted a swift unwinding of carry trades, and investors' concerns that further rate hikes by the Bank of Japan could harm Japan's fragile economic recovery and that the yen's appreciation could severely impact large exporters like Toyota led to a "flash crash" in the Japanese stock market—resulting in multiple trading halts and dragging down the global stock market.

When the yen appreciates rapidly, the risks associated with yen-based carry trades significantly increase. Since speculators borrow in yen, if the yen appreciates, leveraged forex traders must repurchase yen at higher prices to repay their loans. This can lead to a substantial reduction in their actual returns and even significant losses. When the yen exchange rate rises quickly, traders often choose to unwind their positions rapidly to cover potential losses, which means selling off large amounts of their liquid global stocks and other risk assets to repurchase yen. Additionally, since the yen is traditionally viewed as a safe-haven currency, some traders may sell stocks on a larger scale to buy yen in order to hedge against risks amid global market turmoil.

Interest rates and government bond yields are key factors driving yen carry trades. The average government bond yield of the top ten high-yield currencies and emerging market currencies exceeds 6%. In contrast, the Bank of Japan's benchmark interest rate is currently only 0.25%, and the yield on yen-based government bonds is nearly zero, which is a core reason why carry trades favor the yen.

Have the scars healed and the pain forgotten? Speculators are reigniting the wave of "yen carry trades."

Although the Bank of Japan is gradually raising interest rates to increase the benchmark rate, the yield gap between Japan and major economies like the United States remains significant. The Federal Reserve lowered the benchmark rate by 25 basis points in November to a range of 4.5%-4.75%, which is still far above Japan's benchmark rate According to Felix Ryan, a foreign exchange analyst at Australia & New Zealand Banking in Sydney, even if Japan raises its benchmark interest rate to around 1%, the logic of yen-based arbitrage trading still holds.

This trading strategy has brought immense profits to leveraged hedge funds in recent years. Statistics show that since the end of 2021, yen financing arbitrage trades targeting 10 major and emerging market currencies have achieved cumulative returns of up to 45%, compared to a return of about 32% for the S&P 500 index when reinvested dividends are considered. This has attracted more and more hedge funds and speculative forces, which is why short interest in the yen reached an astonishing $21.6 billion by the end of July, just before a frenzy of unwinding in the foreign exchange market.

Charu Chanana, chief investment strategist at Saxo Bank, stated, "The Bank of Japan's interest rate hike is unlikely to be enough to eliminate the yield gap between Japan and the United States. Given that U.S. debt and fiscal conditions are clearly one of the key areas of focus for the incoming Trump administration, even if faced with occasional unwinding, yen arbitrage trading may still have room to maintain its funding attractiveness."

Yen yields remain far below other major currencies - average weekly implied three-month yields from currency forwards

In recent months, market speculation that Trump's tariffs and tax cuts would boost the U.S. economy while also raising U.S. inflation has led to a rapid surge in the dollar and U.S. Treasury yields. However, this market concern has eased after Trump nominated Scott Basset, who has been outspoken about controlling the deficit, as Treasury Secretary.

Yasuki Ohmori, chief Japan strategist at Mizuho Securities in Tokyo, still stated that Trump will ultimately decide U.S. fiscal policy. "In the end, it's all about Trump," Ohmori said, emphasizing that arbitrage trading may reach a new peak as early as January next year. "People are forgetting the risks posed by Trump's influence on Basset. If Basset wants to keep this position, I don't think he will be so stubborn on budget issues."

Trump's presidency could trigger a new round of global trade wars and could put significant pressure on global assets, especially after the president-elect vowed last week to impose tariffs on China, Canada, and Mexico. Although the Mexican peso has long been the preferred currency for yen financing arbitrage trades due to its double-digit interest rates, Trump's remarks could trigger enough volatility to make this trade less attractive.

This is important because yen financing arbitrage trades benefit from reduced volatility in the foreign exchange market. Despite the rising uncertainty under the new government led by Trump, the foreign exchange volatility index compiled by JP Morgan has fallen from its post-pandemic peak Nevertheless, some analysts remain pessimistic about the prospects for yen carry trades, as the narrowing interest rate gap may weaken the momentum for carry trades next year, especially after Bank of Japan Governor Kazuo Ueda opened the door for a rate hike in December. Japanese officials are also cautious about the yen's exchange rate, with Japan's Finance Minister warning last month that the yen has experienced significant one-way fluctuations since the end of September.

The yen is one of the worst-performing sovereign currencies among the Group of Ten (G10) this year, as structural issues such as massive capital outflows and yield differentials continue to put pressure on the yen's exchange rate. Although the yen appreciated to 140 yen per dollar during the unwinding of carry trades a few months ago, it has now fallen back to around 150 yen per dollar.

Jane Foley, head of foreign exchange strategy at Rabobank, stated, "The Japanese Ministry of Finance has re-engaged with speculators through verbal intervention, and the recent tough rhetoric from Bank of Japan Governor Kazuo Ueda is fueling expectations for a rate hike in December." "While carry trades have gained further support, this should ensure that the carry trades lack the clear confidence and momentum seen in the spring of this year."

Before the monetary policy meetings of the Bank of Japan and the Federal Reserve in December, investors may have a clearer outlook on the prospects for yen carry trades. If Ueda's comments are more dovish, or if Federal Reserve Chairman Jerome Powell's remarks are more hawkish, along with key data points—such as any indications from U.S. non-farm payroll data and unemployment rates—there could be a significant re-entry of forces into yen carry trades.

"If the Bank of Japan indicates that the pace of rate hikes will slow, and if Powell does not intend to cut rates quickly, then the interest rate differential will have significant appeal for carry trades," said Omori. "The Japanese Ministry of Finance is not being that aggressive, and if they remain silent, investors may feel there is no reason not to engage in such trades to profit at low-cost levels."