The yen fell even after the Bank of Japan raised its policy rate to 1.25%, the highest level in 31 years, while estimates emerged that the yen carry trade could be worth as much as approximately $2.3 trillion. Expectations of another rate hike by the Federal Reserve and the persistence of the interest-rate differential are driving yen weakness, while attention is also turning to the flow of overseas funds.
At its monetary policy meeting on the 18th, the Bank of Japan raised its target for the uncollateralized overnight call rate by 0.25 percentage points, from 1.00% to 1.25%, its highest level since 1995. The yen, however, fell immediately afterward, and continued to weaken on the 22nd. The market is signaling yen weakness against a backdrop of a sustained US-Japan interest-rate differential. Ray Attrill (レイ・アトリル), Head of FX Strategy at National Australia Bank, said the Bank of Japan's policy decision fell short of market expectations, raising doubts among investors.
The issue is the sharp expansion in cross-border yen borrowing. According to an analysis by Jefferies cited by the Financial Times, yen borrowing increased 67% between December 2021 and this March and is expected to reach ¥360 trillion in total, or approximately $2.3 trillion. The yen carry trade involves borrowing low-yielding yen and investing in higher-yielding currencies, although not all yen borrowing is directly linked to carry trades.
The risk of a yen carry trade unwind is substantial. In the past, there have been instances in which an unwinding accelerated when Bank of Japan rate hikes coincided with movements in US interest rates. UBS and other experts have warned that a faster pace of additional Bank of Japan rate hikes could drive a rapid appreciation of the yen, while a sharp unwinding could destabilize markets. The analysis describes a dilemma for the Bank of Japan: gradual rate hikes could expand the yen carry trade, while rapid hikes could trigger a large-scale unwinding.
Some believe overseas investment flows are more active than the unwinding. Overseas assets held by Japanese investors, including US equities and bonds, total approximately $2.5 trillion, nearly half of the approximately $5 trillion in overseas portfolio assets. Japan Post Insurance plans to invest ¥2 trillion in US infrastructure, among other investments, and some observers say funds will continue to flow into overseas assets despite rising domestic interest rates.