The sharp rally in the Japanese yen has reshaped investors’ calculations in the currency market as the Bank of Japan meeting approaches amid strong expectations of an interest rate hike next week. The Japanese currency has received support from several drivers at once, most notably signs of capital repatriation, rising bets on monetary tightening, and growing U.S. pressure after the yen fell in July to its weakest level in 40 years, prompting a joint intervention by Washington and Tokyo. The importance of this move goes beyond the exchange rate itself, extending to carry trades that have for years relied on borrowing cheaply in yen and directing liquidity into higher yielding currencies and assets.
The yen’s latest rise has started to put direct pressure on this strategy, as a stronger Japanese currency raises the cost of existing positions and pushes investors to reduce exposure or close positions entirely. Jefferies estimates, based on data from the Bank for International Settlements, show that cross border yen borrowing reached a record 360 trillion yen, or about $2.35 trillion, by March, marking the largest buildup in carry trades in three decades. This large size means that any sudden unwinding of positions could create broad market disruption, especially if short yen covering turns into a self reinforcing move.
The yen’s break through key levels against the dollar accelerated the move, as it strengthened to 152.89 per dollar, its highest level since February, after trading around 160 less than a week earlier. This rapid shift suggests the market was not fully prepared for the strength of the move, while stop loss orders played a role in speeding up the decline in USD/JPY. As the pair fell below 155, a new wave of short yen covering began, both from leveraged funds and real money investors.
The situation is no longer tied to speculation alone, as investors are now pricing in a broader shift in Japan’s monetary policy path. Tokyo Tanshi data points to a 97% probability of a 25 basis point rate hike to 1.25%, compared with only 52% a month earlier, with further increases still possible in October and December. Although this pricing reflects strong confidence in a Bank of Japan move, it also raises the risk of disappointment if Governor Kazuo Ueda delivers a tone that is less hawkish than markets expect, which could expose the yen to a quick correction.
The difference this time compared with the 2024 episode is that markets are more prepared for the possibility of sustained tightening by the Bank of Japan, while domestic yields in Japan have become more attractive. The yield on 10 year Japanese government bonds is trading near its highest level in 30 years, meaning capital no longer has the same need to leave Japan in search of returns. Therefore, if the yen holds its gains after the September 18 meeting, it may signal a genuine repricing of the funding side of carry trades rather than a temporary squeeze on positions.
At the same time, intervention risks remain present in traders’ minds, making the rebuilding of large short yen positions more sensitive. Japan’s previous interventions and the record decline in its foreign securities holdings show that Tokyo is prepared to use its tools when necessary. As a result, yen funded carry trades are no longer the easy opportunity they once were, but now carry a political and monetary risk premium, especially with the next stage tied to both the Bank of Japan and Federal Reserve meetings in the same week.
Japanese economic data gave the yen additional support after second quarter GDP growth was revised higher to an annualized 1.4%, above both the initial estimate and forecasts of 1.1%. Although growth slowed from 1.8% in the first quarter, the stronger reading suggests the economy still retains some momentum, especially with external demand rising 0.5%. On the other hand, private consumption remained flat, while capital expenditure fell 0.9%, reflecting continued domestic weakness despite real wages improving by 2.4% in July, their strongest increase since May 2021.
This picture gives the Bank of Japan room to proceed with a rate hike, but not a blank check to move too aggressively. The Japanese central bank is balancing the need to contain inflation driven by yen weakness and higher import costs against the risk of shocking companies and households after decades of extremely low interest rates. Therefore, the most likely scenario remains a 25 basis point hike, with the possibility of faster increases later, perhaps once every quarter, if price pressures and the labor market continue to support tightening.
The yen’s strength has extended to Asian currencies, with most of them improving against the dollar as the U.S. Dollar Index fell to 98.81, while USD/JPY declined by 0.7% to 153. Dollar weakness comes ahead of U.S. inflation data, which represents the final major reading before the Federal Reserve meeting on September 15 and 16, while markets are pricing in roughly a 60% chance of a U.S. rate hike after the strong jobs report. This overlap between Federal Reserve and Bank of Japan expectations has made the currency market more sensitive to any new data, especially after the yen gained around 4.5% from the 160 level within just a few days.
In South Korea, the won benefited from strong foreign inflows into the equity market and a rally in semiconductor stocks. Economic growth also supported the broader picture after Korea’s economy expanded by 0.6% quarter on quarter and 3.7% year on year in the second quarter, helped by chip exports that offset weaker construction investment. However, the speed of the won’s recent rise may make it harder to sustain the same pace in the coming period.
The key question now is the size of the Bank of Japan’s next move. Although a 50 basis point hike would send a strong signal that the bank does not want to fall behind inflation, this scenario remains outside the base case because shocking markets and a public used to low borrowing costs could prove costly. Therefore, a 25 basis point hike remains the more likely path, with markets focused on the bank’s tone after the decision. If the message is firm enough, the yen may extend its gains and the carry trade unwind could deepen. If the tone falls short of market expectations, USD/JPY could rebound quickly and old positions may partially return.
Stay informed about global markets through our previous analyses. and Now, you can also benefit from LDN company services via the LDN Global Markets trading platform.
