The Great Unwind

How Japan’s Yen Carry Trade Became the Grave-Digger of Global Finance

In the early morning hours of July 31, 2026, an extraordinary event happened in global currency markets when the Japanese yen, which had been languishing at 40-year lows against the dollar, suddenly spiked. Over the span of about fifty minutes, the currency suddenly surged nearly 3%, catching traders around the world off guard.

Preliminary data from the Bank of Japan suggests that authorities have likely conducted another yen-buying intervention to the tune of around 6 trillion to 7 trillion yen. This follows prior interventions of 11.7 trillion yen during the Golden Week holidays in April and May, which themselves followed record interventions of 15.3 trillion yen in 2024 and 9.2 trillion yen in 2022. What made this particular intervention different, however, was coordination between Tokyo and Washington, with Japan’s top currency diplomat, Atsushi Mimura, stating that Japan was “receiving support from the U.S. authorities that goes beyond mere emotional support.”

Let’s talk about what exactly this all means, and why the U.S. feels the need to prop up Japanese currency in this way. The answer to the second question is straightforward. The U.S. was forced to take action because Japan is the largest foreign holder of U.S. Treasuries, with over $1.2 trillion in holdings. Should Japan run out of dollar reserves to defend its currency, it would have to start selling them, which in turn would send yields spiking and put American bond markets at risk. But what’s less obvious is why Japan holds such an incredible amount of Treasuries in the first place. The answer lies in Japan’s staggering government debt and the unconventional policies it adopted to manage it.

Japan has more government debt relative to the size of its economy than any developed country in the world. We’re talking about over 200% of GDP here. By every textbook measure, a country with that much debt should have collapsed decades ago. Greece collapsed with far less, and Argentina was forced to defaulted with far less as well. Yet Japan somehow has not.

The secret to Japan’s survival was a three-decade-long experiment with zero interest rates that turned Japanese money into a pillar of global finance. And in doing so, it made the United States dangerously dependent on Japanese capital. That experiment is now ending, and with it, a reckoning for the U.S. economy.

The Miracle That Became a Trap

Back in the 1980s, Japan was the world’s economic miracle. At one point, the land under the Imperial Palace in Tokyo was worth more than all the real estate in California combined. Then the bubble popped in the early 1990s after the U.S. forced the Plaza Accord on Japan, which triggered three decades of deflation, something no modern economy had ever experienced. Prices and incomes stayed flat, as the economy stagnated.

In February 1999, the Bank of Japan did something unprecedented to fight the deflationary spiral by cutting interest rates to virtually zero. This was the first time any major central bank had done this, making money in Japan essentially free to borrow for the next 25 years.

This financial trick allowed Japan to survive its debt mountain. When you owe 200% of GDP but pay virtually no interest on that debt, the burden becomes manageable. Since the cost of carrying the debt was essentially nothing, the government could borrow endlessly without worrying about interest payments eating up the budget.

The whole thing came down to whom Japan owes all that money. When Greece collapsed and Argentina defaulted, they owed money to foreign investors who sold their assets, leading to a crisis. But Japan owes the money to itself, with the Bank of Japan holding about 48% of all Japanese government bonds, Japanese insurance companies holding another 20%, and Japanese banks with around 14%. Total foreign holdings account for less than 8% of Japan’s overall debt. What we see here is essentially a closed loop which could be financed internally at zero cost.

And that’s how the system worked for the past three decades. But, as always, this policy produced unintended consequences that are now converging to reshape global finance, turning the United States into a hostage to Japanese monetary policy.

The Birth of the Yen Carry Trade

Having a debt loop which could be controlled internally allowed Japan to avoid printing money at the rate the rest of G7 countries have been doing for the last 20 years. Since 2004, the U.S. money supply grew by about 279%, Canada grew by 368%, but Japan grew by only 90%, keeping its money relatively scarce and its interest rates at zero. That combination created something called the yen carry trade.

If you were a hedge fund, a bank, or an investor, you could borrow yen at 0% interest and then convert it to dollars. Now you could turn around and buy basically anything in the world that paid you more than zero. For example, buying U.S. Treasuries would net you 4% or 5% interest, and you’d be making free money on the spread between Japanese interest rates. It was the closest thing to a risk-free arbitrage that global finance has ever seen.

So, it should be no surprise that the yen carry trade grew to gargantuan proportions as a result. By one estimate from the Bank for International Settlements, yen-funded carry trades measured about $1.7 trillion, while others range as high as $4 trillion. At the end of March 2025, Japan’s own foreign portfolio investments totaled 666.86 trillion yen, which is about $4.54 trillion, and more than half of that was in interest-rate-sensitive debt assets.

Naturally, Japanese investors joined the party as well, with pension funds, insurers, banks, and households all shipping their money overseas to get some of that interest. And that’s essentially the process which led to Japan becoming the world’s biggest foreign holder of U.S. government debt today.

As of December 2025, Japan held approximately $1.2 trillion in U.S. Treasury securities, making it the largest foreign holder of U.S. federal debt, and accounting for roughly 12.8% of all foreign investment in U.S. publicly held debt. Treasury data shows that Japan actually increased its holdings by $115.5 billion in 2025 alone, bringing them to a staggering $1.2 trillion in 2026.

But Japan’s exposure goes far beyond direct Treasury holdings because the Government Pension Investment Fund, which is the world’s largest pension fund, has $1.8 trillion in assets. The fund holds roughly $931 billion in foreign assets which include $232.1 billion in U.S. Treasuries alone. Japanese life insurers, which together hold about 390 trillion yen or $2.6 trillion in invested assets, have for years turned to foreign debt to secure higher returns for all the reasons explained above.

So, when the U.S. borrows money or tech stocks go up, there is a good chance that there is Japanese money somewhere in that process. And what that means is that American stock and bond markets are built, in part, on borrowed Japanese capital.

The Unraveling Begins

This whole system was built on Japanese interest rates being at close to zero, but now, inflation has finally come to Japan. The pandemic, broken supply chains, and the recent energy crisis resulting from the war on Iran have all pushed global inflation higher. By 2022, Japan already had 2% inflation for the first time in decades. While other countries raised rates to fight inflation, Japan held theirs at zero, and that decision started the process of breaking the yen.

Every time someone does that trade, they are selling yen and buying dollars, creating a constant flow of yen being dumped on the market and dollars being purchased. The intent of borrowing yen isn’t to hold it, but to convert it into something else. And that conversion is what creates supply of yen and demand for dollars. So when I say that money flows out of yen and into dollars, I am talking about investors getting rid of yen and acquiring dollars, which is what the carry trade is. The supply of yen in the global market increases because everyone is borrowing it and selling it, and the demand for dollars grows because everyone is buying them to invest in U.S. assets.

Logically then, when the U.S. pays 5% on cash and Japan pays near-zero, money has to flow out of yen and into dollars. But what happens when you have increasing supply of something and increasing demand for something else? The price of the yen must fall relative to the dollar here. So, the more people borrow yen to do the carry trade, the more yen gets sold, and the weaker the yen becomes, creating a feedback loop. As the yen gets weaker, the carry trade becomes even more profitable because not only do you earn the interest rate differential, but the currency also moves in your favor. Consider what happens if you borrow yen at 0% and convert it to dollars at 110 yen per dollar; then the yen falls to 160 per dollar. The yen dropping means that repaying the loan becomes that much cheaper, and you profit on the currency move as well as the interest spread.

So the loop here is that the carry trade makes the yen weaker, and the weaker yen makes the carry trade more attractive, which brings in more participants who sell more yen, weakening it even further. The structural flow of capital is overwhelmingly happening in one direction here because the demand for yen from people who want to buy Japanese assets or hold yen is dwarfed by people borrowing it and selling it to do the carry trade, driving its price down. The yen has been collapsing from around 110 per dollar to 150, then 160, which is its lowest level against the dollar in about 40 years. The last time the yen was this weak, Ronald Reagan was president and Nintendo had just come out.

Now, the central bank can try to counteract the problem by creating artificial demand to support the price, which is precisely what Japan has been doing with its interventions. But as long as the interest rate differential remains large, the incentive to borrow yen and sell it remains unchanged. The Ministry of Finance can buy yen all it wants, but investors simply borrow and sell even more yen the next day. Hence, attempts at intervention have been predictably ineffective. Japan spent up to $900 billion buying its own currency, but the carry trade is a multi-trillion-dollar structural flow that is simply much larger than what it can offset.

To make matters worse, Japan has almost no natural resources of its own, meaning it imports nearly all of its energy, which happens to be priced in dollars. Thus, we can see a vicious cycle in which the collapsing yen makes imports increasingly expensive, driving up inflation and putting the yen under even more pressure.

For three decades, Japanese workers never really asked for pay raises because prices stayed relatively stable, and a flat cost of living allowed people to get by on their existing pay. But once inflation took off, workers started demanding pay raises for the first time in 30 years, and they are getting them.

And, once wages and prices start chasing each other higher, it is really hard to put that genie back in the bottle. So, the Bank of Japan had little choice but to start raising rates. In 2025, the policy rate went from 0.50% in June to 0.75% by December, and markets expect further hikes to 1.0% by mid-2026, with a terminal rate between 1.25% and 1.5%.

Now recall Japan’s 200% debt-to-GDP ratio, which every rate increase makes more expensive to carry, since rate hikes make the yen less attractive for carry trades. The higher these rate increases get, the more Japanese capital ends up coming back home.

Japan can now either try to keep rates at zero, making its high levels of debt manageable, or to increase interest rates in an attempt to save the yen. The first option leads to currency devaluation and inflation eating retirees’ savings, as a country of savers gets poorer every single month. But picking the second option means that 200% of debt to GDP starts accruing real interest, and the bond market that’s been asleep for 30 years starts to wake up. The Bank of Japan, which owns half of those bonds, starts bleeding losses on its own balance sheet, having to pay interest on its very high levels of debt. There is no third option where everything stays the same way that it was before. The choice Japan faces is to save the currency or the bond market.

The Great Repatriation

There is now a growing consensus on Wall Street that a great repatriation of Japanese capital is underway. For the first time in a generation, Japanese bonds are actually paying something with the 30-year JGB now paying around 4% [4], making them attractive to Japanese pension funds and insurance companies. A Japanese government bond allows them to invest using their own currency without having to worry about exchange rate risk. Hence, Japanese money is starting to return home for the first time since the 1980s. And the policy is fully endorsed at the highest levels. On July 10, 2026, Japan’s finance minister announced that the government wants the GPIF, the world’s biggest pension fund, to start moving its investments into Japanese assets [15]. Such a move affects roughly $232 billion in U.S. Treasuries alone, plus hundreds of billions of dollars in U.S. stocks.

Similarly, Japanese life and casualty insurance companies, which were net sellers of Japanese bonds for most of the last two years, have now flipped to being the biggest buyers. And that money is coming from selling U.S. Treasuries with the dollars being converted back to yen, reversing the entire carry trade scenario.

For decades, Japan was the most reliable customer at U.S. bond auctions, but now it is starting to sell instead. Fewer buyers force the U.S. to offer higher interest rates to attract new ones, which is partially why U.S. Treasury yields are at elevated levels today. The 10-year yield has been hovering near 4.7%, which is close to multi-decade highs while the 30-year yield has pushed toward 5.3%. Even issuing short-term 2-year notes costs the government 4.3% in interest. So, we see every maturity on the yield curve moving higher simultaneously.

As the yen strengthens against the dollar due to Japanese investors converting their dollars back to yen, it also reduces demand for U.S. debt, pushing yields higher. Higher yields translate into higher borrowing costs for the U.S. government, which already runs a 5.9% deficit. They also mean higher mortgage rates for American homeowners and higher corporate borrowing costs for American businesses.

Here we see how the unwinding of the carry trade affects the entire economy in the U.S., affecting everyone regardless of whether they hold Japanese assets or not. When a major foreign buyer of our debt steps back, the U.S. has to offer higher rates to attract new customers, and the cost gets passed on to everyone who borrows money in America.

The yen carry trade directly affects hedge funds and global investors borrowing yen to buy U.S. stocks, tech shares, and risk assets. When the yen strengthens, all those trades become unprofitable or even lose money in the worst case. So, investors end up unwinding their positions in U.S. assets to buy back yen instead.

We’ve seen this happen before back in August 2024, when the Bank of Japan raised rates by just a quarter of a percent. The yen strengthened, and Japan’s stock market fell by 12% in one day in the worst day since 1987. The U.S. stock market also dropped 3%, and American investors watched their portfolios lose money as the S&P 500 fell 6% while the Nasdaq dropped 8%. Yardeni Research attributed the selloff directly to the unwinding of yen carry trades, and the Bank for International Settlements dutifully documented how the unwinding of leveraged positions, including carry trades, amplified extreme equity market volatility.

Historically, the yen strengthening rapidly has always translated into a market panic. In 1998, the yen went up 15% in three days as Long-Term Capital Management collapsed. In 2008, the yen rose all year as the global financial crisis unfolded. In 2011, the yen hit record highs, creating ripples through global markets. In March 2020, the yen spiked again during the COVID crash. There is a consistent pattern here because assets must be sold so that borrowed yen can be repaid, and the selloff is global because the yen-funded investments are global.

The difference now is that the yen strengthening is not a response to crisis, but is a result of a policy goal. Japan wants its money to come home, meaning that the unwind of the yen carry trade is the plan.

The Selection Pressures That Led to This Moment

To understand how we arrived here, we have to look at the selection pressures that shaped the global economic system over the previous decades.

Japan has long struggled with demographic challenges caused by its low birth rate. An aging population means fewer workers and less disposable income, which in turn leads to shrinking domestic demand, creating persistent deflationary pressure. Keeping rates at zero was essential to prop up such a low-consumption economy.

A separate pressure came from global demand for yield, because Western central banks also pushed interest rates to near-zero after the 2008 financial crisis. Investors around the world were desperate for anything that paid a positive return, and Japanese capital was the only cheap money left. This turned the carry trade into the primary mechanism for global investors to get leverage.

On top of all that, the U.S. government has been running deficits for decades, needing foreign capital to fund them. Japanese capital allowed the U.S. government to spend beyond its means without having to face the consequences of higher interest rates, creating another major pressure.

All these factors combined created a self-reinforcing system where Japan needed to keep rates low to survive, cheap Japanese capital was used to fund speculation around the world, and the U.S. relied on Japanese buyers to manage its debt. The system operated in a state of precarious dynamic equilibrium, which had to be maintained in order for it to remain stable.

Now we see this delicate balance coming apart because the underlying conditions had changed. Global inflation broke the deflationary trend in Japan, forcing wage increases for workers. The war in the Middle East sent energy prices higher, which made Japan’s import dependency even more painful. And foreign buyers for the U.S. bonds were becoming scarce due to the growing deficit.

The Battle of Wills

To recap, the whole thing started with Japan using zero interest rates policies to manage its debt-to-GDP ratio. Zero rates, in turn, led to the carry trade with Japanese capital flowing out to fund global speculation, creating asset bubbles in the West. While the struggle between yen weakness and global asset prices was contained for a long time, the underlying contradiction was never resolved.

We are now entering a perfect storm scenario where Japan is forced to intervene to stop the yen from falling further. These interventions feed short sellers betting that the yen would go down regardless, making bets on a specific direction of movement of the yen.

Interventions strengthen the currency temporarily, and short sellers see this as an opportunity. The short sellers sell yen when it is high, which is what shorting is, and then wait for it to weaken again. At that point, they cover their short by buying it back at a lower price and pocketing the difference. The short sellers are not interested in the long-term trajectory of the yen; all they care about is the short-term volatility created by the intervention.

The traders know that the Ministry of Finance cannot keep buying yen forever due to its limited reserves and political will. So the intervention must stop eventually, at which point the natural forces that drove the yen down in the first place reassert themselves. The yen inevitably falls, allowing the short seller to cover their position at a profit and then wait for the next intervention to repeat the cycle.

Thus, each intervention becomes less effective because it only serves to attract more short traders. The quantitative accumulation of these interventions led to a qualitative change in market expectations. The traders, having observed dozens of interventions over years, learned that none of them stop the yen from falling. So, the long-term trend remains downward, and the interventions start being seen as a sign of weakness.

These market expectations become self-reinforcing because when traders believe that Japan cannot stop the yen from falling, they have no reason to keep holding it. And more people shorting the currency makes it fall further. Hence, the more the yen falls, the more the market believes Japan is unable to arrest the trend.

Now, we are entering a new phase dominated by the repatriation of Japanese capital which is causing the yen to strengthen, which forces the short sellers to unwind their positions. The carry trade unwinding becoming a policy choice marks a period of qualitative change within the system. Japan’s debt problem that was exported abroad is now becoming one that the world must deal with, as the consequences of that debt come home.

The Implications for Western Finance

As we saw, the Western financial system was largely built on Japanese capital which is now leaving. Meanwhile, the U.S. Treasury market has long provided the foundation for global finance, serving as the risk-free benchmark for everything else. And its stability is now under threat from yields being pushed ever higher as a result of Japan selling off U.S. bonds.

The U.S. annual deficit already sits at 5.9% of GDP, and it only keeps growing. Even if spending could somehow be cut, the Congressional Budget Office projects that interest expense on the national debt, at over a trillion per year already, will keep creeping up. If, in addition to that, yields go up because Japan keeps dumping bonds, the deficit could hit 7%, 8%, or even 9% of GDP within the next decade. And that kind of rate hike is simply unsustainable for an economy built around low borrowing rates.

Meanwhile, corporate America is even more exposed since the AI bubble, which accounts for 2-3% of U.S. GDP growth, is also built on cheap credit. Tech giants like Alphabet, Amazon, Meta, Microsoft, and Oracle have priced roughly $110 billion in corporate bonds this year alone. Investment-grade corporate issuance has now cleared $976 billion, which is well ahead of the pace seen in the past five years.

Hyperscalers, in particular, are slated to spend at least $700 billion in 2026 on AI infrastructure, which is a jump of about 80% from last year, while cumulative data-center capex for the 2025-2028 period is estimated at $2.5 trillion. All of these projects would be under threat from rising yields driving up borrowing costs. Simply put, the hyperscalers would not be able to continue their capex spending if borrowing costs got too high. And when AI spending stops, the U.S. enters a major recession because so much of the economy is tied into the AI bubble at this point.

So, now we see why the U.S. cannot allow Japan to sell off Treasury bonds to prop up the yen, and has to take measures to arrest the meltdown of the Japanese financial system. But the U.S. also has no way of stopping Japanese capital from repatriating, because those decisions are made by pension funds and insurance companies responding to market signals, putting the United States in an impossible position.

And this all explains why the U.S. is coordinating with Japan in an attempt to stabilize the situation. Treasury Secretary Scott Bessent publicly acknowledged that the yen “seems very undervalued,” which is an indirect admission that the dollar itself is overvalued. He then proceeded to sell euros to buy yen on behalf of the Treasury, effectively throwing Europe’s currency under the bus to prop up Japan. Notably, this was the first direct U.S. intervention in currency markets in nearly thirty years.

But these are all mere delaying tactics rather than long-term solutions. The reality is that the United States has spent decades living beyond its means, and that era is now coming to an end. Bessent is fighting gravity here because the markets have already decided that the yen has entered a doom spiral and will continue to short it. And since U.S. Treasury yields have become correlated with Japanese yields, that’s dragging the U.S. financial system down as well. It’s also worth noting that the borrowing costs in the U.S. are already far too high for comfort, and inflation-adjusted borrowing at the long-end of the curve is at levels last seen just before the Global Financial Crisis of 2008. The U.S. must either reduce its spending, raise taxes, or accept permanently higher interest rates. All of these options will require major structural changes in the American economy going forward.

And so, we have the full picture of how the contradictions within the global financial system built on Japanese capital have finally come to a head. Yen interventions can only be effective for so long, as we’ve discussed earlier. When they fail, Japan will slip into a crisis that will inevitably spread to the market for U.S. Treasuries. From there, it has the potential to take down the AI sector and the equity markets. At that point, we might be looking at the collapse of the entire USD system.

The United States finds itself in a particularly vulnerable position with its unsustainable deficits and a bond market dependent on foreign buyers who are now leaving. American growth is driven by a technology bubble that cannot be sustained without access to cheap capital. These structural problems cannot be solved through currency interventions, and replacing Japanese capital with domestic savings cannot happen overnight. Should the U.S. economy crash, the contagion will quickly spread across other Western-aligned economies that are tightly integrated into the American financial system.

Every time the yen strengthened rapidly, markets somewhere broke, and this time, a stronger yen is the plan. What happens next is anybody’s guess, but the pattern is not encouraging for the West. The contradictions of the system have finally reached the point where they can no longer be swept under the carpet. A qualitative change in the global financial system is now unavoidable.