What’s the likelihood of Yen carry trade reversing?

UBS analysts have stated that a significant reversal of the yen carry trade is highly unlikely, despite a surge in Japanese government bond yields. In a report published on October 14, the bank's rates and foreign exchange strategists expressed a very low probability of a substantial reversal, asserting that the trade remains attractive even with rising borrowing costs in Japan.

The yen carry trade entails borrowing in Japan's low-interest-rate currency and investing in assets that yield higher returns internationally. Should such a reversal occur, investors might be compelled to sell foreign assets and buy back yen, which could potentially destabilize global markets. However, Japanese bond yields have increased by around 140 basis points over the past two months, which is offset by global yield increases, thus maintaining the interest rate differentials that sustain carry trade strategies.

UBS anticipates the yen to remain weak, while its Japanese macroeconomic team projects the Bank of Japan interest rates peaking at approximately 2% within the next year, contrasting with market expectations for further interest rate hikes. Furthermore, UBS assessed which emerging markets might be affected if Japanese investors started repatriating their capital.

The United Arab Emirates, Singapore, Australia, South Africa, and India have particularly high Japanese equity ownership relative to their overall market capitalization, making them potentially vulnerable to altered investment flows. Historically, Korean and Brazilian equities have shown heightened sensitivity to rising Japanese government bond yields.

However, South African, Korean, and Thai equities have generally outperformed during periods of yen appreciation, indicating that the impact is not uniform across markets. Materials stocks have traditionally benefited from a strong yen, according to the analysts. Despite these risks, UBS maintains a positive outlook on emerging-market equities, citing robust earnings growth and more attractive valuations following the June-July sell-off.

The bank singled out Korea, Brazil, and China as its favored markets, arguing that improving corporate earnings could mitigate the risks associated with tighter global financial conditions.