For decades, the Japanese yen was the world’s favourite funding currency. Borrow yen at near-zero rates, invest in higher-yielding currencies, pocket the difference. The Australian dollar, with its historically higher interest rates, was one of the most popular carry trade targets.

That trade is unwinding. And the implications for the AUD are more significant than most Australian investors appreciate.

What Changed in Japan

The Bank of Japan ended its negative interest rate policy in March 2024 and has raised rates three times since, bringing the policy rate to 0.75% as of January 2026. Market expectations suggest another 25 basis point hike is likely by mid-2026, potentially taking the rate to 1.0%.

By global standards, 0.75% is still very low. But the direction matters more than the level. After twenty-five years of zero or negative rates, Japan is normalising monetary policy. Each rate increase reduces the interest rate differential between JPY and higher-yielding currencies like the AUD.

The AUD-JPY interest rate differential has compressed from roughly 4.35% at its peak (when the RBA was at 4.35% and BOJ was at -0.10%) to about 3.35% now. If the BOJ hikes to 1.0% while the RBA cuts to 3.85%, the differential shrinks to 2.85%.

These numbers may seem abstract, but they drive enormous capital flows. The yen carry trade is estimated at hundreds of billions of dollars globally. Even partial unwinding moves markets.

How the Carry Trade Works (and Unwinds)

The carry trade is straightforward in concept: borrow in a low-yield currency, convert to a high-yield currency, invest in interest-bearing assets, earn the rate differential minus transaction costs.

AUD/JPY carry trade mechanics:

1. Borrow JPY at 0.75%
2. Sell JPY, buy AUD
3. Invest AUD at 4.1% (or higher in money market instruments)
4. Earn approximately 3.35% per year (before costs)

This works brilliantly when AUD/JPY is stable or rising, because you earn the rate differential plus any capital appreciation. It works terribly when AUD/JPY falls, because currency losses can overwhelm the interest income.

The carry trade unwinds when:

• The yield differential narrows (happening now)
• Volatility increases, raising the risk of adverse currency moves
• Risk sentiment deteriorates, causing “risk-off” capital flows back to safe-haven JPY

An unwind means participants reverse the trade: sell AUD, buy JPY. This puts downward pressure on AUD/JPY.

What We’re Seeing in AUD/JPY

AUD/JPY traded as high as 109 in July 2024. It currently trades around 97. That 11% decline reflects progressive carry trade unwinding and JPY strengthening.

The move hasn’t been smooth. AUD/JPY experienced a sharp sell-off in August 2024 when the BOJ’s rate hike triggered a rapid yen carry trade unwind. AUD/JPY fell from 108 to 95 in three weeks. It recovered partially but has been trending lower since.

Positioning data from the CFTC Commitment of Traders reports shows speculative short JPY positions have declined by roughly 40% from their 2024 peak. The carry trade is unwinding gradually, with occasional sharp episodes.

The concern is that further BOJ tightening could trigger another sharp unwind. The August 2024 episode demonstrated how quickly orderly carry trade unwind can become disorderly liquidation.

The Transmission to AUD/USD

AUD/JPY and AUD/USD are correlated but not identical. However, yen carry trade dynamics affect AUD/USD through several channels.

Direct selling pressure. When carry traders exit AUD/JPY positions, they sell AUD. Some of this selling occurs against JPY specifically, but in practice, many carry trade unwinds are executed via AUD/USD and USD/JPY legs separately. This means AUD/USD experiences selling pressure during carry trade unwinds even though the primary trade is AUD/JPY.

Risk sentiment contagion. Carry trade unwinds tend to occur during periods of risk aversion. When JPY strengthens sharply, it signals risk-off conditions that weigh on all risk-sensitive currencies, including AUD/USD.

Cross-rate arbitrage. If AUD/JPY falls sharply while USD/JPY is stable, the implied AUD/USD rate declines. Cross-rate traders will sell AUD/USD to maintain consistency, transmitting the move across pairs.

Scenarios for the Rest of 2026

Base case: Gradual unwind continues. BOJ hikes once more in 2026 while the RBA begins modest easing. AUD/JPY drifts lower toward 90-93. AUD/USD experiences mild additional pressure from carry trade flows, contributing to a grind toward 0.6100-0.6200.

Bull case for AUD/JPY: Chinese stimulus drives commodity prices higher, supporting AUD. BOJ pauses after one more hike as Japanese inflation moderates. AUD/JPY stabilises around 95-100. Carry trade unwind slows.

Risk case: Disorderly unwind. BOJ signals more aggressive tightening than markets expect, or a global risk event triggers rapid yen strengthening. AUD/JPY falls sharply toward 85-88, with significant AUD/USD spillover pushing the pair toward 0.5900-0.6000.

The risk case deserves particular attention because carry trade unwinds are inherently non-linear. They proceed gradually until they don’t. The August 2024 episode saw AUD/JPY fall 5% in a single week. A similar move from current levels would take AUD/JPY to 92 and likely push AUD/USD below 0.62.

How to Position

For AUD/JPY traders, the trend is your friend until it isn’t. The intermediate trend remains bearish (lower highs, lower lows since July 2024). Trading with this trend—selling rallies rather than buying dips—aligns with both the fundamental picture (narrowing differential) and technical picture.

Stop losses are essential in carry trade-sensitive pairs. The potential for sharp, gap moves during BOJ meetings or risk events means tight stops can be blown through. Consider using options for downside protection if maintaining AUD/JPY long positions.

For Australian investors with Japanese assets (or vice versa), currency hedging is more important than usual. The AUD/JPY relationship is entering a period of structural change after decades of relative stability.

The yen carry trade has been a background driver of the AUD for so long that many Australian investors take it for granted. With the BOJ normalising policy for the first time in a generation, that background driver is shifting. Understanding the mechanics of carry trade unwinding isn’t optional anymore—it’s essential for anyone with AUD currency exposure.