Reassessing Yen Carry Trades in a Shifting Japan: Implications for Global Risk Appetite

The global currency landscape is undergoing a recalibration as Japan's evolving monetary and political dynamics reshape the calculus of yen carry trades. For investors, the interplay between the Bank of Japan's (BOJ) cautious normalization of policy and the country's political turbulence presents both risks and opportunities. This analysis examines how these developments are likely to influence the yen's role in global risk appetite and the viability of carry trade strategies.

Monetary Policy: A Delicate Balancing Act

The BOJ has maintained its benchmark interest rate at 0.50% since March 2025, a pause in its tightening cycle driven by uncertainties around U.S. trade policies and domestic inflation trends, according to a FocusEconomics report. While inflation remains within the 2.5%-3.0% range-primarily fueled by food prices-the central bank has signaled two more rate hikes expected by year-end, contingent on wage growth and global economic stability, according to Trading Economics data. This measured approach reflects a broader normalization strategy, including the planned reduction of Japanese government bond (JGB) purchases and the sale of ETFs and REITs to unwind years of quantitative easing, as outlined by the Bank of Japan.

However, the BOJ's path is not without constraints. A potential delay in rate hikes could prolong yen weakness, reinforcing the appeal of carry trades. Conversely, a faster-than-anticipated tightening cycle might narrow yield differentials with the U.S. Federal Reserve, which is widely anticipated to begin rate cuts in 2025, according to an IBAFin analysis. Such a scenario could dampen demand for yen-based borrowing, forcing investors to reassess their exposure to high-yield currencies like the Australian dollar or the New Zealand dollar.

Political Uncertainty: A Wild Card for Fiscal Policy

Japan's political landscape has added a layer of complexity. Prime Minister Shigeru Ishiba's resignation in September 2025, following the Liberal Democratic Party's (LDP) historic loss in the upper house elections, has triggered a leadership contest, according to Kiplinger, with Sanae Takaichi, a conservative hawk, as a leading candidate. A Takaichi-led government could prioritize expansive fiscal stimulus to secure cross-party cooperation, potentially increasing public debt and upward pressure on long-term bond yields-an outcome highlighted by Lombard Odier. Such measures might weaken the yen further, bolstering carry trade dynamics.

Conversely, a shift toward fiscal discipline or a return to Abe-era economic policies could stabilize the yen, narrowing the yield gap with other major currencies. The outcome of the October 4 leadership race will be critical in determining whether Japan's fiscal trajectory amplifies or mitigates the BOJ's monetary normalization efforts, as noted in a Britannica entry.

Global Risk Appetite: A Tug-of-War Between Yen Weakness and Geopolitical Tensions

The yen's performance is inherently tied to global risk sentiment. A weaker yen typically encourages carry trades by making Japanese borrowing cheaper, but this dynamic is now being tested by broader geopolitical risks. U.S. tariffs and regional tensions with China and North Korea have introduced volatility into trade-dependent economies, tempering risk-on sentiment, cautions the Carnegie Endowment. Meanwhile, the U.S. Federal Reserve's anticipated rate cuts could reduce the incentive to seek higher yields outside Japan, creating a tug-of-war between yen carry trade demand and macroeconomic caution.

Investors must also consider the indirect effects of Japan's political instability. A fragmented government may struggle to implement coherent economic policies, increasing uncertainty for global markets. This could lead to a flight to safety-favoring the yen as a haven currency-contradicting the typical carry trade logic, as discussed in a Markets article.

Strategic Implications for Investors

For those engaged in yen carry trades, the key variables to monitor are the BOJ's next rate hike timing, the outcome of Japan's leadership contest, and the Fed's policy trajectory. A delayed BOJ tightening cycle or a Takaichi-led fiscal expansion would likely sustain yen weakness, making carry trades more attractive. However, a faster BOJ normalization or a Fed pivot to rate cuts could erode the yield advantage, prompting a rebalancing of portfolios.

Diversification remains critical. While yen carry trades offer potential returns, they are inherently vulnerable to sudden shifts in monetary policy or geopolitical shocks. Investors should hedge against yen volatility by incorporating other low-yield currencies or adjusting leverage levels. Additionally, the rise of alternative carry trade pairs-such as the Swiss franc or the euro-may provide more stable returns in a fragmented global policy environment, according to FocusEconomics.

Conclusion

Japan's monetary and political developments are creating a pivotal moment for global currency strategies. The yen's role in carry trades is no longer a straightforward function of interest rate differentials but a complex interplay of policy normalization, fiscal experimentation, and geopolitical risk. As the BOJ navigates its path toward tighter policy and Japan's political leadership shifts, investors must remain agile, recalibrating their exposure to yen-based strategies in light of evolving macroeconomic signals.