BoJ Shocks With ETF Unwind Plan as Yen Weakens — Is the Carry Trade in Danger?

The Bank of Japan (BoJ) kept its policy rate unchanged at 0.5% this week but surprised markets with a hawkish tilt, signaling that its long era of ultra-loose policy is inching toward normalization. Alongside the hold decision, the BoJ announced it would begin unwinding its massive $250 billion portfolio of exchange-traded funds (ETFs) and real estate investment trusts (JREITs)—an unprecedented step that could take more than a century to fully execute. The move, combined with two dissenting votes on the policy board in favor of a rate hike, underlines a gradual but notable shift in tone under Governor Kazuo Ueda. While not a rate hike, the message was clear: Japan’s central bank is preparing markets for a new chapter.

For investors, the news was more hawkish than anticipated. A 7-2 split vote is rare for the BoJ, which usually presents a united front. The dissenting members argued for an immediate 25 basis point hike, a signal that pressure to normalize policy is building. Analysts quickly interpreted this as a sign that markets should begin pricing in a rate hike before year-end, with October or January emerging as likely windows. Japanese equities reacted negatively, with the Nikkei 225 swinging from a fresh record high in morning trade to close down 0.57% on the day. The yen, however, weakened against the dollar, moving from ¥145 before the Federal Reserve’s midweek rate cut to ¥147, underscoring that investors may not have been shocked by the BoJ’s decision.

The decision has broad implications for global bond markets. With the Fed cutting rates and the BoJ hinting at eventual tightening, yield differentials between U.S. Treasuries and Japanese government bonds could narrow, pressuring one of the most crowded trades in global finance: the yen-funded carry trade. For years, global investors have borrowed cheaply in yen to finance purchases of higher-yielding assets elsewhere. As long as Japanese rates remained pinned near zero, the strategy was relatively safe. But signs of normalization in Tokyo complicate that equation, particularly as the U.S. yield curve adjusts lower with Fed easing. A sustained rise in Japanese yields could unwind portions of the carry trade, triggering volatility across global risk assets, especially in emerging markets where carry flows are most pronounced.

Ironically, the yen’s immediate move suggests investors remain skeptical that the BoJ will move quickly. While Ueda acknowledged that core consumer inflation has remained above the BoJ’s 2% target for more than three years, he stressed that “underlying inflation is still somewhat below 2%, but approaching that level.” He pointed to fading food inflation and risks from U.S. tariffs as reasons for caution. This explains why the yen weakened post-decision: traders see normalization as glacial rather than aggressive. Ueda himself quipped that, at the planned pace, selling the BoJ’s ETF and JREIT holdings could take more than 100 years—a reminder that even “hawkish” steps in Japan are executed with extraordinary patience.

The global bond market response has been more nuanced. U.S. Treasury yields were little moved, as investors focused more on the Fed’s own rate cut this week. However, the prospect of even modest upward pressure on Japanese yields could prove significant in the months ahead. Japanese institutional investors, including insurers and pension funds, are among the largest holders of Treasuries and European sovereign debt. If rising domestic yields offer a more attractive home, even at the margin, repatriation flows could exert pressure on global fixed-income markets. This is particularly relevant at a time when Western central banks are easing, creating an unusual divergence between U.S. and Japanese policy.

The political backdrop in Japan adds further complexity. Inflation remains an explosive issue for households, as wages have struggled to keep pace with rising prices. The ruling Liberal Democratic Party faces an emergency leadership election, introducing uncertainty just as the BoJ embarks on a delicate policy shift. Any further weakening of the yen risks fueling higher import costs, compounding consumer pain. For Ueda, the balance is precarious: move too slowly and inflation expectations could entrench; move too quickly and risk derailing fragile domestic demand.

For the Federal Reserve, the BoJ’s cautious hawkishness complicates the global policy mosaic. The Fed’s decision to cut rates has weakened the dollar only modestly, in part because yen softness has offset downward pressure. If the BoJ were to follow with a hike in coming months, dollar-yen could face sharper two-way risk, disrupting currency markets long accustomed to one-directional moves. In turn, the carry trade could lose appeal, leading to broader repricing in leveraged strategies.

In short, while the BoJ kept rates steady, the combination of ETF unwinding, dissenting votes, and inflation above target was more hawkish than markets had braced for. The immediate weakening of the yen reflects skepticism about the pace of normalization, but the seeds have been planted for a shift with global ramifications. Bond investors will be watching closely for any signs of repatriation flows, while equity markets must digest the potential overhang of gradual BoJ ETF sales. For the Fed, the divergence underscores a rare dynamic: as U.S. policymakers ease, Tokyo is tiptoeing toward tightening. That juxtaposition could define global capital flows into 2025.