Yen carry trades are teetering on the edge of a cliff. Since the summer of 2023, the USD/JPY exchange rate has consistently maintained levels above the 140 threshold, but the current dual pressure from Japanese rate hike expectations and US rate cut pressures could become the "final straw" that breaks this two-year-long carry trade pattern. Should USD/JPY experience a significant decline, yen appreciation could trigger a chain reaction across global asset allocations.

The market currently sits in a delicate balance: Japan's inflation rate continues to exceed the central bank's target, with second-quarter GDP growing at an annualized rate of 1% far surpassing market expectations, while weak US non-farm payroll data combined with President Trump's calls for rate hikes have put the Federal Reserve in a difficult position. The Bank of Japan has been criticized for "lagging behind," and US Treasury Secretary Bessent's statements further highlight policy divergence pressures.

**Japanese Bond Yields Surge, Rate Differential Under Pressure**

Against this backdrop, 10-year Japanese government bond yields have climbed significantly between 2024 and 2025, currently approaching the 1.58% technical resistance level. This level was previously seen in 2008 and has been tested multiple times by the market in recent months. A successful breakthrough of this resistance could trigger a chain reaction: on one hand, Japanese bond yields could rise further to 1.86%; on the other hand, the yield spread between US and Japanese 10-year bonds could narrow significantly.

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Specifically, the current spread between US 10-year Treasury yields and Japanese government bonds of the same maturity (US yield minus Japanese yield) has continued to oscillate within the 2.75%-2.8% range since September 2024, with this support level facing renewed testing recently. Notably, this spread trend has formed a "descending triangle" technical pattern, and if it breaks below the support level, it could further decline to around 2.3%.

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From a historical perspective, the USD/JPY exchange rate and the US-Japan 10-year bond yield spread have long exhibited high correlation, but recent periods have shown temporary divergence. Similar situations occurred in the summer of 2024, ultimately resulting in the exchange rate falling back and reconverging with the spread trend. Current market analysis suggests this divergence phenomenon may repeat itself.

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**USD/JPY Approaches 140 Unwinding Threshold**

It's worth noting that the historical correlation between USD/JPY and the US-Japan rate differential has recently shown cracks. A similar divergence occurred in summer 2024, ultimately resulting in the exchange rate falling back to align with the differential, and the current market is betting on a "repeat of history."

More concerning is the 5-year USD/JPY cross-currency basis swap, which has formed a "rising triangle" bullish pattern, suggesting that the hedging costs for borrowing USD are declining. This creates dual pressure for Japanese investors holding US dollar assets: they face both foreign exchange losses from yen appreciation and declining returns from shrinking hedging premiums.

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Technically, USD/JPY is approaching the critical 140 support level. If this position is breached, it could trigger large-scale unwinding of carry trades—since July 2023, it has been carry trade demand that has supported USD/JPY consistently above 140.

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**Summary**

Although the current correlation between yen strength and the Nasdaq 100 index is weaker than last year, historical experience shows that rising risk-aversion sentiment often accompanies yen appreciation. After multiple tests of key resistance levels in interest rate and currency markets, the market widely expects that this two-year carry trade feast may reach its conclusion sooner than most anticipate.

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