The Japanese yen is on track for its strongest weekly gain since November 2024, driven by growing market confidence that Prime Minister Sana Takaichi's commanding majority in the lower house will enable the government to expand economic stimulus while maintaining bond investors' trust in fiscal discipline. The yen has appreciated against the US dollar for four consecutive sessions, strengthening approximately 2.8% so far this week. Furthermore, robust safe-haven demand, fueled by a massive sell-off in stock markets due to AI disruption fears and intensified selling of risk assets like cryptocurrencies, is providing additional support for the currency.

However, the yen's sharp appreciation has raised concerns among some investors about the risk of large-scale unwinding of yen carry trades, which could trigger significant volatility across stock, bond, and currency markets. Investors interpret Takaichi's decisive victory as reducing political uncertainty and lowering the risk of the worst fiscal outcomes, which has helped boost the yen and pushed down yields on long-term Japanese government bonds from the multi-year highs touched last month.

At a press conference on Monday, Prime Minister Sana Takaichi acknowledged market concerns regarding a proposed two-year food tax cut and reiterated plans to avoid financing the measure by issuing massive amounts of bonds. "Following the Liberal Democratic Party's overwhelming victory, the fading of fiscal worries and rising expectations for a Bank of Japan rate hike are driving the yen's strengthening trend," said Takeshi Yamamoto, a market trader at Sumitomo Mitsui Trust Bank in New York.

Japan's top currency official, Atsushi Mimura, stated that despite the yen's significant rise this week, the government remains highly vigilant about foreign exchange fluctuations. Market concerns that US and Japanese authorities might jointly intervene to support the yen have also helped limit the currency's decline.

"After Prime Minister Sana Takaichi led the LDP to a historic victory, traders are beginning to price in a policy mix rare for Japan—tax cuts without worsening the deficit, potentially supported by internal funding pools. The risk is that this could involve large-scale sales of foreign reserves—short-term positive for the yen due to buying, but also increasing FX market volatility due to a lack of a clear financial script for how far officials are willing to go," said Michael Ball, a macro strategist at Bloomberg Strategists.

Previously, on January 23, the yen strengthened sharply following reports about the New York Federal Reserve conducting "rate checks," but it subsequently weakened after US Treasury Secretary Scott Bessent stated the US "absolutely" had no intention of intervening in the forex market. However, recent comments from Japanese Finance Minister Satsuki Katayama, who said she maintains close contact with Bessent and shares a significant responsibility with him to maintain stability in the USD/JPY pair, have somewhat revived expectations of joint intervention.

Significantly heightened expectations for a Bank of Japan interest rate hike are also a core driver behind the yen's ascent. Recently, several members of the BOJ's policy board have emphasized the need for the central bank to raise rates "in a timely manner." Overnight index swaps now indicate a 78% probability of the BOJ restarting rate hikes in April. Investors will closely monitor a speech by BOJ policy board member Naoki Tamura on Friday, along with US CPI data, to gauge the outlook for the US-Japan interest rate differential and the yen's trajectory.

A Sword of Damocles Hangs Over Global Markets: The Yen Carry Trade The yen carry trade acts like a Sword of Damocles suspended over global risk asset markets, including equities, cryptocurrencies, and high-yield corporate bonds. This strategy is essentially a highly leveraged cross-market financing and risk exposure. When fundamental drivers change—such as a narrowing yield differential or a strengthening yen—it can not only quickly become unprofitable but also amplify shocks through a series of market feedback mechanisms, potentially impacting global stock markets that are hitting record highs and remain in a bull trend, and possibly even affecting global bond and currency markets.

A recent report from strategists at Wall Street research firm BCA Research described the yen carry trade as a "ticking time bomb in global financial markets." Against the backdrop of rising BOJ rate hike expectations and the potential for Takaichi's stimulus policies to drive a surge in long-term JGB yields, this long-popular hedge fund strategy faces the risk of large-scale unwinding, which could trigger severe reverse shocks.

The Bank of Japan's longstanding ultra-low interest rate environment has made yen-funded borrowing extremely cheap. Investors have thus borrowed in yen to invest in higher-yielding risk assets, such as US stocks, developed market bonds, and emerging market assets, to capture the interest rate differential. This model of generating returns via low-cost yen funding was heavily adopted during periods of abundant global capital and high risk appetite, accumulating massive leveraged positions. Over time, these positions have become a systemic risk point touching global markets, as they depend on the persistence of the yield differential and a weak yen.

However, if risk assets decline, the yen strengthens sharply, or Japanese government bond yields surge wildly, this carry trade can unravel rapidly. Rising BOJ hike expectations, coupled with upward pressure on long-end JGB yields from fiscal stimulus/supply concerns, would undermine the foundation of the "borrow yen, buy high-yield asset" trade and increase the probability of forced deleveraging if risk sentiment sours.

While fiscal stimulus might, in the short term, allow the carry trade to persist via a "risk-on/weaker yen" dynamic, a large-scale unwind is typically triggered by a combination of factors: rising hike expectations, deteriorating risk sentiment, and a strengthening yen, rather than any single variable in isolation.

The BCA team, led by veteran strategist Arthur Budaghyan, believes this carry trade structure risks a rapid unwinding similar to those seen in 2008, 2015, and 2020. During those periods, a rapid deterioration in global risk sentiment triggered sudden deleveraging, prompting investors to scramble to buy the safe-haven yen.