The Bank of Japan kept its policy rate at 1.25% on Oct. 30, two days after the Federal Reserve held its target range at 3.75% to 4%. That leaves a gap of 2.5 to 2.75 percentage points between short-term dollar and yen rates, and it is the reason the yen carry trade, a leveraged bet that the Bank for International Settlements once sized at about US$250 billion, still pays.

For investors in Asia, the trade matters well beyond Tokyo. When carry positions are built, cheap yen flows into higher-yielding assets around the world. When they are pulled at once, the yen can surge and equities across the region can fall together, as they did in August 2024.

How a yen carry trade works

The mechanics are simple. An investor borrows in a currency with low interest rates, converts the money into one with higher rates, and earns the difference. For most of the past decade the yen was the obvious funding currency, because Japanese short-term rates sat near or below zero.

A stylized example shows both the payoff and the risk. Borrow yen at roughly the BOJ's 1.25% policy rate, buy dollar assets paying close to the Fed's 3.75% to 4% range, and the investor collects about 2.5 percentage points a year before costs. That cushion is thin. If the yen strengthens about 2.5% against the dollar over the same year, the currency loss erases the interest gain. At the Nov. 2 level of about 157.86 yen per dollar, reported by Trading Economics, that is a move to roughly 154.

So carry traders are, in effect, betting that the yen stays weak or drifts weaker. Leverage magnifies the return, and it magnifies the damage when the bet turns. The trade can be run through bank loans, foreign exchange forwards and swaps, or simply by holding a short yen position in currency futures, which is why its size is hard to pin down.

The Bank for International Settlements tried. In a bulletin published Aug. 27, 2024, BIS economists put the stock of yen-funded carry trades going into that month's turmoil at a rough middle estimate of 40 trillion yen (US$250 billion), and said the figure was, if anything, biased down by data gaps.

What happened in August 2024, and why it is relevant now

The BIS described the August 2024 episode as a case of leveraged positions in currencies and equities being unwound together, which amplified the market reaction to a weak U.S. economic release. FX carry trades, it said, were hit hard. Markets calmed quickly, but the BIS warned that the forced selling and margin increases behind the episode were structural features of the financial system that policymakers should keep watching.

The setup today differs in one important way: the funding leg is no longer free. The BOJ has been raising rates, and its Oct. 30 statement shows the pressure to go further. Board member Hajime Takata voted against the hold and proposed lifting the policy rate to 1.5%, arguing in the statement that underlying inflation had reached the 2% target and the bank needed to move faster toward a neutral rate. The board's Outlook Report said underlying consumer price inflation was now generally consistent with the 2% goal and that inflation risks were skewed to the upside.

Every BOJ hike raises the cost of borrowing yen and narrows the spread that carry traders live on. The other side of the spread would shrink only if the Fed cut, and it is not cutting. Its Oct. 28 statement said inflation "remains elevated," and two of the 12 voters, Lisa D. Cook and Beth M. Hammack, wanted a quarter-point increase. A Fed that hikes while the BOJ hikes would keep the gap roughly where it is.

Bank of Japan, the yen and what Asian investors watch

The yen's reaction to the BOJ shows how sensitive positions are. According to Reuters, the currency rose to as high as 157.115 per dollar after the decision, erasing most of its losses for October. Masahiko Loo, chief fixed income strategist at State Street Investment Management in Tokyo, told Reuters the debate was now about "where the terminal (rate) lands," with his base case around 1.75%.

By Monday the yen had slipped back toward 158, Trading Economics reported, as Finance Minister Satsuki Katayama repeated that Tokyo was ready to act against excessive moves. The yen's level, the ministry's past dollar sales and the reserves behind them are covered in our editorial on Japan's 27 trillion yen currency defense.

For a carry trader, official intervention and BOJ hikes are the same kind of risk: a sudden yen rally that turns a steady income stream into a loss. That is why a hawkish BOJ matters to holders of assets across Asia, not only to Japanese exporters: a rush to repay yen borrowing can force sales of whatever was bought with it.

The BOJ's own view of risks lists foreign exchange developments alongside the Middle East and AI-related demand as factors to watch. For details of last week's decision, see the BOJ's 8-1 vote to hold at 1.25%.

Japan's wage data, due this week according to Trading Economics, is the next input traders will use to judge whether the BOJ lifts the cost of borrowing yen again at its December meeting.