U.S. President Donald Trump seems to be back in deal mode. New trade deals with South Korea and the European Union have been completed, while negotiations with China are seemingly heading in the right direction. However, the recent completion of the U.S.-Japan trade deal shed light on another topic, the ‘carry trade’.
The carry trade is a common trading strategy that takes advantage of interest rate differentials between two countries. While the carry trade exists in many forms, the relationship between Japan and the United States has long been at the centre of this strategy.
In this post, we’ll break down how the carry trade works, explain why Japan and the U.S. are so deeply linked in this dynamic, and explore how shifting interest rate policies in both countries could spell trouble for investors relying on this age-old tactic.
Carry Trade Explained
Before diving into the carry trade between Japan and the U.S., we first need to know what a carry trade is and how it works.
To put it simply, a carry trade refers to any strategy that involves an investor borrowing capital at a low interest rate and using that capital to buy an asset with potentially higher returns. Carry trades are most common in foreign exchange markets, where they involve borrowing in a low-interest-rate currency and investing in a higher-yielding asset denominated in another currency (such as a bond).
Step by step the process is.
Borrow capital in a low-interest-rate currency (e.g., Japanese yen)
Convert the borrowed capital to a higher-yielding currency (e.g., U.S. dollars).
Invest in an asset denominated in the new currency (e.g., U.S. government bonds).
The goal is to profit from the spread (the ‘carry’) between the cost of borrowing and the return on your investment.
To be effective, a carry trade needs to be completed in the right environment. Firstly, the exchange rate between the two currencies must be relatively stable. Large swings in the exchange rate can increase currency risk, which can wipe out gains made in the carry trade (and even create losses). Secondly, the interest rate differential between the two currencies needs to remain wide enough to justify the trade.
Carry trades are popular because, when conditions are right, they can generate consistent and solid returns over time. As a result, in correct conditions, hedge funds, institutional investors, and FX traders frequently use carry trades as part of their broader investment strategies.
Japan–U.S.: A Staple Strategy
Now that we’ve broken down how the carry trade works, it’s worth looking at why Japan and the U.S. have become such key players in this strategy. Their roles haven’t developed by accident; they’re shaped by years of contrasting economic policies and interest rate environments.
Japan – The World’s Funding Currency
For decades, Japan has played a central role in global carry trades, largely because of the country’s ultra-low interest rates. This approach began in the 1990s after Japan’s asset price bubble burst, triggering a prolonged economic slowdown and deflationary pressure. In response to the crisis, the Bank of Japan (BoJ) slashed interest rates to near-zero and implemented a highly accommodative monetary policy to combat deflation and stimulate the stagnating economy by making borrowing cheaper and encouraging spending. Over the following decades, Japan continued to face deflationary pressures, keeping interest rates near zero.
This long-standing environment is the key to what has made the Japanese yen the go-to funding currency for investors. Having borrowing costs near zero gives traders the opportunity to secure capital cheaply and deploy it into higher-yielding investments elsewhere. Having such low rates for so long has anchored Japan on one side of the carry trade for years, and the yen remains the standout funding currency to this day.
The U.S. – A High-Yield Destination
On the other side of this equation lies the U.S. The United States has long offered some of the most attractive returns for investors around the world, with U.S. government bonds being one of the most attractive assets for those completing a carry trade. Compared to Japan’s near-zero interest rates, U.S. Treasury yields have remained relatively high, generally staying between 2% and 5% over the last couple of decades.
U.S. government bonds are also considered to be one of the safest and most liquid assets in the world, which further enhances their appeal. This combination of yield, safety and liquidity makes U.S. treasuries a standout asset for carry traders when deciding where to deploy their borrowed capital. As long as a solid gap between Japanese and U.S. rates remains, U.S. bonds will likely remain a favoured target for carry traders. However, current trends indicate that might not be the case.
Shifting Rates: A Threat to the Carry Trade
The long-standing gap between the Japanese and U.S. rates is starting to narrow, and the carry trade is under threat. For years, the strategy has thrived thanks to predictable low Japanese rates and solid U.S. yields. But shifts on both sides of the equation are challenging this dynamic.
After decades of ultra-loose monetary policy, the BoJ has slowly started hiking interest rates, with rates currently sitting at 0.5%. For years, deflation plagued Japan, even as other economies experienced price increases. However, that began to change in the aftermath of the COVID-19 pandemic. Global inflation surged, driven by supply chain disruptions, energy price rises, and demand fuelled by stimulus packages. These Covid inflationary pressures spilt over into Japan, taking them out of their period of deflation.
As well as this, rising import costs and upward pressure on wages spurred inflation further, taking it to above the BoJ’s target of 2%.
In response, the BoJ are shifting away from their historic interest rate environment, tightening rates to deal with the latest inflationary pressures.
On the other hand, in the U.S., the trend is moving in the opposite direction. The Federal Reserve is currently in a rate-cutting cycle, and it is under increasing pressure to cut rates faster. Donald Trump has been increasingly vocal of his opinion that the Fed should be cutting further. Also, falling services inflation and jobs growth in the U.S. are applying further pressure on the Fed to cut. Taking these pressures into consideration, it looks likely that U.S. interest rates will continue to come down, potentially even faster than previously anticipated.
With the BoJ hiking and the Fed cutting, the interest rate differential between the two countries is shrinking, and therefore, so is the spread on Japan-U.S. carry trades. As the gap between rates tightens, the potential returns from carry trade investors fall, making it less attractive to large investors. If this trend continues, we could begin to see an unwinding of the Japan-U.S. carry trade. Given that this interest rate gap has persisted for decades, a significant amount of capital is tied up in yen-funded trades. Some analysts estimate that as much as $4 trillion is currently parked in these strategies. A mass unwinding of a trade of this size could have serious consequences for global markets.
First, if investors begin selling off U.S. Treasuries rapidly to exit their positions, yields could spike, destabilising fixed-income markets and pushing up borrowing costs more broadly.
Second, as capital flows back into yen to repay loans, the surge in demand could strengthen the yen and weaken the dollar. These sharp currency moves can disrupt companies and investors exposed to dollar-yen exchange rates, especially those involved in trade or cross-border financing.
Finally, the volatility caused by an unwinding of this scale could lead to a broader shift in market sentiment toward risk aversion. Emerging markets and other high-yielding assets, which are often funded through similar carry trades, may face capital outflows, falling asset prices, and currency stress.
The Road Ahead
Carry trades are undoubtedly a powerful tool for generating consistent steady returns when global interest rate environments align and are stable. The Japan-U.S. carry trade especially has been a lucrative operation for traders and investors, thriving off ultra-low borrowing costs in Japan and attractive yields in U.S. assets.
However, this strategy may be taking a turn for the worst. With Japan slowly hiking rates back up to combat their newfound inflation and America deep in a cutting cycle, the gap that made this trade so effective is narrowing. If these trends continue, we could be in for a seriously large-scale unwinding. This event won’t just shake bond and currency markets but will send shockwaves throughout global economies.
After decades of being a safe bet, could this carry trade be turning into a costly risk?
