A dollar funding squeeze is unwinding the yen carry trade for the second time in two years

Carry trades do not end because someone rings a bell. They end because funding gets more expensive at the same moment the asset stops appreciating, and the two effects compound through leverage until the position closes itself. That process began in the second week of September and it is not finished. The yen has gained 5.8 per cent against the dollar in eight sessions. Three month cross currency basis has gapped to its widest level in three years. European credit funds, not Japanese retail accounts, are doing most of the selling.

The shape of this unwind differs from the episode in August 2024. That one was retail led, violent and over in six sessions. This one is institutional, slower, and rooted in a funding market rather than a speculative one. The trigger was not a policy surprise in Tokyo. It was the reinvestment decision in Washington on Wednesday, which pushed the long end of the Treasury curve higher and made the dollar leg of the trade unattractive on a hedged basis for the first time this year.

Why the hedged yield matters more than the headline yield

A euro based pension fund buying a ten-year Treasury does not earn 4.53 per cent. It earns 4.53 per cent minus the cost of rolling a three month currency hedge, and that cost is set by the policy rate differential plus the basis. With the basis at minus 42 basis points and the differential where it is, that arithmetic now produces a negative number. The fund would be paying for the privilege of owning a US government bond.

This is the mechanism connecting a funding market in London to the auction calendar in Washington. Foreign official and private buyers took down a meaningful share of long-dated Treasury supply through the first half of the year, and they did it because the hedged yield beat the equivalent domestic government bond. Strip that advantage away and the bid does not vanish overnight, but it stops growing, and the domestic buyer has to clear the market at a higher yield. The curve steepening story and the currency story are the same story told from two desks.

Everyone models the carry trade as a yen story. It is a dollar funding story with a yen funding leg attached, and the funding leg is where the stress shows up first.

Annika Sorbo, head of G10 strategy at Norwood Quay

Where the leverage sits

Estimating the size of a carry position is guesswork dressed up in decimal places, so treat the following as an order of magnitude. Norwood Quay puts the increase in yen denominated cross border bank lending since March at about $195bn, and estimates that roughly 60 per cent of it funded dollar assets rather than domestic Japanese ones. Add the futures positioning data and the picture is of a trade that was around $310bn at its August peak and has shed perhaps 45 per cent of that.

• European credit funds used yen funding to buy dollar investment grade paper, which is why US credit spreads and USD/JPY have correlated at 0.71 over the past month against 0.18 for the year.
• Macro funds ran the trade through three month forwards, which roll every quarter and therefore reprice the funding cost immediately when the basis moves.
• Japanese domestic institutions are the natural other side and have been buying the yen rally, which caps the speed of the move but does not reverse it.
• Emerging market carry funded in yen, mostly Mexican peso and Brazilian real, has underperformed the G10 leg by about four percentage points over the same eight sessions.

September quarter end is the complication. Dealer balance sheets contract into the reporting date, the basis almost always widens further in the final ten days, and any fund already paying more for dollars will pay more again in about two weeks. That is a known seasonal, which usually means it is priced. It is not always priced when the starting point is already the widest level in three years.

Quarter end will be noisy and the noise will look like a crisis to anyone who has not traded through one. The level to watch is where the basis settles in the second week of October.

Ines Marchetti, head of rates strategy at Harrow Lane Capital

The European angle

For European investors the sequence compounds. Hedged dollar assets have become unattractive precisely as domestic sovereign curves offer more yield than they have in a decade, and the French to German ten-year spread sits at 84 basis points into a contested budget round. Capital that has spent three years travelling west has a reason to stay home, and a reason to demand more from long-dated euro paper as well. Both conclusions point the same direction: steeper curves on both sides of the Atlantic, and a dollar that weakens on flow rather than on rate differentials.