Hedge funds are unwinding bearish yen positions as expectations for further Bank of Japan tightening drive a sharp rally in the Japanese currency and put pressure on one of the market’s most established carry trades, according to a report by Bloomberg.
The yen gained more than 2% against the dollar on Thursday, taking it to a one-month high and close to levels last reached in May following Japanese authorities’ intervention in the currency market. It held most of those gains on Friday.
The move has been reinforced by increasingly hawkish signals from BOJ Governor Kazuo Ueda and board member Hajime Takata, with markets raising their expectations for additional rate increases. Nomura has said the central bank could potentially deliver three consecutive hikes through December in an extreme scenario in which continued yen weakness adds to pressure for tighter policy.
For hedge funds and other leveraged investors, the shift represents a growing challenge to yen-funded carry positions. The strategy typically involves borrowing yen at Japan’s relatively low interest rates and investing the proceeds in higher-yielding markets such as the US, Brazil or Mexico.
Those trades can generate attractive returns while the yen remains weak or stable. But a stronger Japanese currency increases the cost of repaying the yen funding, while rising volatility can accelerate position unwinds.
Evidence of defensive positioning was visible in the options market on Thursday. Trading volume in dollar-yen call options expiring this month was more than 2.5 times that of puts, according to CME data, suggesting investors were buying protection against further yen appreciation and covering short-yen exposure.
Japanese rates have also moved sharply higher. Two-year government bond yields have risen about 14 basis points this week, while swap markets are pricing a 25-basis-point BOJ increase at the Sept. 18 meeting and almost three further moves of the same size by July.
Such a pace would represent a significant acceleration from the central bank’s average of roughly two rate increases a year since the beginning of 2024.
The impact has extended beyond the dollar. Higher-yielding currencies including the Brazilian real, South African rand and Mexican peso each fell by more than 1% against the yen on Thursday as carry positions came under pressure.
There may still be considerable scope for further short covering. Commodity Futures Trading Commission data showed leveraged funds held a net short yen position of 81,619 contracts in the week ended Aug. 25, while asset managers were net short 18,284 contracts.
The prospect of a September BOJ hike, combined with expectations that policymakers will retain flexibility over the pace of subsequent tightening, has encouraged investors to reduce those bearish positions.
Japanese exporters have also reportedly increased dollar sales in exchange for yen, providing another source of demand for the currency.
Bank of America said the yen’s advance appeared to reflect a broader reduction in risk rather than activity from one particular group of investors.
The bank said the BOJ would need to deliver a meaningful hawkish surprise to generate a lasting repricing of the yen-funded carry trade.
