The dollar's strength is quietly risking another yen 'carry trade' blowup

By Isabel Wang

A potential yen intervention could force another rapid unwind of the 'carry trade'

There's a lot riding in markets on the current yen-dollar balance.

For investors, a stronger dollar doesn't mean as much as the artificial-intelligence spending boom nor blowout tech earnings - especially when AI is the one theme that matters to the entire stock market.

But buried in the recent strength of the greenback is a building risk. It wasn't so long ago that one thing took major stock indexes down overnight: the blowup of the Japanese yen "carry trade."

A carry trade is a strategy where investors borrow money at a lower interest rate to invest in assets with potentially higher returns. It's best known for its use in foreign-exchange markets, where funds borrow in a cheaper currency, such as the Japanese yen (JPYUSD), and invest in higher-yielding assets denominated in the dollar, such as U.S. technology stocks or Treasurys. The idea is that cheap borrowing can boost returns.

That trade may be coming back to a head. The U.S. dollar DXY has been climbing on expectations that the Federal Reserve will keep interest rates higher for longer under new Fed Chair Kevin Warsh, while the yen slipped to a new 40-year low against the dollar this week, before giving back some of those losses on Thursday. The yen was at 162.38 against the dollar on Wednesday afternoon, according to FactSet data. That stretched the gap between the two currencies and made the carry trade even more attractive.

Yet the trade could work as powerfully in reverse. If the yen suddenly strengthens further - whether because Japanese authorities intervene or the rate gap between the two currencies narrows - investors could be forced to unwind those positions rapidly. That might mean buying back yen and selling risky assets to repay their loans.

A looming concern is that Japan could look to proceed with a currency intervention to prop up its economy during the U.S.'s Fourth of July holiday. That could spark a currency reversal and a wave of selling across the U.S. stock market that could echo the Bank of Japan's interest-rate hike in 2024, which triggered forced selling in the U.S. assets and a three-day slump for the S&P 500 SPX.

"Now that the U.S. jobs data has come in much softer, Japanese authorities have even more reason to use the opportunity to sell more of [Japan's] dollar reserves to help lower the USD/JPY exchange rate," Fawad Razaqzada, global macro market analyst at Forex, told MarketWatch on Thursday. "This is especially the case given the U.S. holiday on Friday, when liquidity conditions will be a lot thinner, amplifying the impact of any intervention."

That's exactly why the yen remains "such a powerful but dangerous funding currency," said Stephen Innes, managing partner at SPI Asset Management. "It is low volatility until it is not. The trick is not to pretend that intervention cannot happen. It is to avoid picking up nickels in front of it."

Japan doesn't want its currency to keep weakening because a weaker yen makes Japanese imports - everything from oil and food to raw materials - more expensive in local currency. That erodes the purchasing power of the yen and feeds into the inflation problem that the Bank of Japan only recently started raising interest rates to fight.

Yet even if the conditions for another carry-trade unwind are falling into place, there's reason to think the fallout may be more contained than the market's shock experience in 2024, according to analysts.

For one, investors won't be caught off guard like they were in 2024, so positioning looks considerably lighter this time and the carry trade doesn't appear nearly as crowded, said Chris Getter, portfolio manager at Simplify Asset Management.

The Bank of Japan, too, has changed its posture. Rather than the unpredictable hints that preceded the 2024 unwind, the BoJ has intervened more regularly so far this year and has been "more active in the market," Getter told MarketWatch in a phone interview.

And then there's the wild card: interest-rate differentials. With the BoJ and the Fed both seeming to stay on monetary-tightening paths this year, or at least keeping borrowing costs higher, the gap between rates could narrow to more than it was two years ago, Getter said. In other words, the carry trade may become less attractive than it was in 2024.

Barron's: What to Know About the Japanese Yen 'Carry Trade' That Is Blowing Up Markets

But that's only half the picture. Higher-for-longer interest rates in the U.S. should support the dollar. That would add to the belief that dollar's strength is here to stay, and could reduce the risk of big currency moves that blow up the carry trade.

The U.S. dollar recently staged a sharp reversal in the first half of 2026, clawing back from a four-year low that followed President Trump's tariff fight. The ICE U.S. Dollar Index, a gauge of greenback's strength against a basket of major currencies, has moved higher since May, up 2.5% so far in 2026, according to FactSet data.

The dollar's recovery has been driven primarily by rising inflation brought on by the U.S.-Iran war, as well as the appointment of Fed Chair Warsh, whose recent comments convinced some that he will adopt a more aggressive stance on inflation and keep interest rates higher for longer.

That doesn't mean currency volatility is off the table - only that the market might be better prepared to absorb it this time around.

"Markets are better at pricing things they know than things they do not," said Naomi Fink, chief global strategist and chief economist at Amova Asset Management. While tech hyperscalers' earnings are "tangible" today, whether policy rates need to adjust remains "less sure, and [will] rely on how inflation expectations evolve," she told MarketWatch on Thursday.

"This means that the probability of switching into a lower-carry, higher-rate regime is probably not nil, and is less easily priced by the market," Fink added. "While there may not be an immediate catalyst to exit the carry trade, the tails are fat and the probability for regime shift remains higher than usual."

In other words, investors shouldn't be complacent, because the risk of a major shift in both countries' interest-rate environments and a painful unwind of the carry trade is still higher than usual.

U.S. stocks have staged a powerful rally so far this year, with semiconductor names leading a blistering run-up to record highs. At last check, the S&P 500 was up 8.6% so far in 2026, while the Dow Jones Industrial Average DJIA had risen 9.2% and the Nasdaq Composite COMP had surged 10.4%, according to FactSet data.

-Isabel Wang

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07-02-26 1437ET