Expectations of interest rate hikes by the Bank of Japan have reignited, with global stock markets facing the looming threat of the "sword of Damocles" hanging overhead: yen carry trades.

The strategy team of the Wall Street renowned investment institution BCA Research recently released a research report stating that yen carry trades are a "ticking time bomb" in the global financial markets. Against the backdrop of expectations of interest rate hikes by the Bank of Japan and the possibility of a sharp increase in long-term government bond yields due to the stimulus policies, this hedge fund strategy that has long been extremely popular among traders faces the risk of massive liquidation, which could trigger a severe adverse impact. This nominally yen carry trade - broadly referring to borrowing and financing in low-yielding yen to purchase higher-yielding assets - has benefited from the stronger "carry return" brought about by overseas investments. However, once risk assets decline or the yen strengthens and Japanese government bond yields soar, this trade will quickly unravel. Expectations of interest rate hikes by the Bank of Japan, combined with the upward trend and volatility of long-term Japanese bond yields triggered by fiscal stimulus/supply pressure, will weaken the trading foundation of "borrowing yen, buying high-yield assets" and increase the probability of forced deleveraging in adverse risk sentiment. Recently, several members of the Bank of Japan's Monetary Policy Committee have also emphasized that the central bank should "hike rates in a timely manner," leading to a rapid increase in market bets on further rate hikes by the Bank of Japan. However, fiscal stimulus in the short term could also allow the yen carry trade model to continue "surviving" through the path of rising risk appetite and weak yen. Therefore, it is not overly focused on a single variable that triggers massive liquidation, but rather a combination of upward revisions in rate hike expectations, weakening risk sentiment, and yen strength. Led by Wall Street veteran strategist Arthur Budaghyan, the BCA team believes that this yen carry trade model faces risks of a rapid collapse, similar to those in 2008, 2015, and 2020. During those periods, the rapid deterioration of global risk sentiment triggered sudden deleveraging, with investors rushing to buy the safe-haven yen. BCA recommends long-term investors to go long on the yen. Looking at the underlying mechanisms of the financial markets, the yen carry trade model is often most afraid of two things: when financing costs are no longer cheap (Japanese interest rates rise, interest rate differentials narrow), and when exchange rates fluctuate negatively (sudden strengthening of the yen leading to "negative carry + exchange rate losses" stacking on top of each other). BCA's latest "time bomb" warning essentially says: when risk assets fall and the yen rebounds (or one happens first), triggering liquidation according to historical experience, they often reinforce each other, leading to major reversals in the yen carry trades. BCA's strategy team wrote in a research report dated February 10th: "Our intuition is that the next major liquidation scenario will also be triggered by a combination of a sharp decline in 'carry assets' and/or a significant rebound in the yen. It is impossible to know which one will happen first. But they have often reinforced each other in the past, resulting in significant reversals in yen carry trades." Therefore, the BCA strategy team advises long-term investors to be long on the yen and short on the dollar. This is the latest warning for this carry trade strategy: as the market focuses on the Bank of Japan raising interest rates in the near future and the yen beginning to rebound from historically weak levels, traders are watching for the Bank of Japan to potentially restart the rate hike process later this year. Since 2026, the yen has risen more than 1% against the dollar, moving it away from the region that could trigger accelerated intervention by the Bank of Japan or the Ministry of Finance in Japan. Currently, the yen is trading around 154.4 yen per dollar, down from around 160 last month, indicating a significant appreciation of the yen. BCA strategists note that it is difficult to give precise estimates of the scale of yen carry trades. However, they stated that multiple statistical indicators show that such trades have been " rapidly spreading" in recent years, involving significant amounts of money. They wrote: "As the yen begins to appreciate, due to the significant diffusion of yen carry trades, the magnitude of the yen's appreciation will be significant." The sword of Damocles over risky assets such as global stock markets The yen carry trade can be seen as a "sword of Damocles" hanging over global risky assets markets such as stock markets, cryptocurrencies, and high-yield corporate bonds. This trading strategy is essentially a highly leveraged cross-market financing and risk exposure, which, when basic driving conditions change (such as narrowing interest rate differentials or yen appreciation), not only quickly becomes ineffective, but also amplifies its impact through a series of market feedback mechanisms, affecting current record highs and still in the bullish trajectory global stock markets, and may even affect global bond and currency markets. For a long time, the Bank of Japan's implementation of a super low-interest rate environment has made borrowing in yen extremely cheap, allowing investors to borrow yen and invest the funds in higher-yielding risky assets (such as US stock markets, Euro-American bonds, emerging market assets, etc.) to earn "interest differentials." This pattern of earning returns through low-cost yen financing has been widely used during periods of ample global capital and high risk appetite, accumulating massive leveraged trading positions. With the passage of time, these positions have become potential risks systematically touching global markets, as they depend on the continuous existence of interest rate differentials and the maintenance of a weak yen exchange rate premise. Once the interest rate differential narrows (such as the Bank of Japan implying or unexpectedly raising rates) or risk appetite declines, the profit basis of the carry trade will be undermined. What is more critical is that when the yen starts to strengthen, carry trade participants face dual pressures: an increase in borrowing costs and the expansion of yen-denominated debts due to yen appreciation. In order to avoid losses, investors often quickly liquidate these cross-market positions by selling the initially acquired high-yield assets to cover the yen loans. This process, known as "unwinding," systematically deleverages, which can rapidly drive up the yen and depress global risky asset prices. Many institutional investors, hedge funds, leveraged accounts, and cross-border capital allocations participate, so once a massive liquidation wave begins, it will generate chained selling pressures on stocks, bonds, commodity markets, and credit assets. When prices of these risky assets plummet rapidly, market liquidity severely contracts, risk aversion sentiment widens, and investors often rush to exchange for safe assets (yen, US Treasury bonds, US dollar cash, gold, etc.), further driving a reassessment cycle from risky assets to safe-haven assets. Dramatic market turmoil in the past, such as 2008, 2015, 2020, was related to the reversal of carry trades or similar fund flow events. The essence of the carry trade is implicit leverage, and once accumulated on a large scale, when reversed, its impact extends far beyond a single asset or exchange rate. For example, it not only affects the USD/JPY exchange rate but may also involve asset prices, volatility indexes, credit conditions, and multiple market transmission pathways. The highly correlated global capital flows will quickly concentrate on low-risk assets due to the reverse, forcing stocks and bonds to be repriced and possibly triggering systemic collapses across asset markets. In other words, this risk is not a "single exchange rate problem" but a "systemic risk" with multiple triggering mechanisms.