The USD/JPY carry trade—borrowing yen at low interest rates to invest in higher-yielding dollar assets—is generating decent returns again. The interest rate differential between the U.S. and Japan is wide enough to make the trade tempting.

But the risks are higher than the smooth returns of the last few months suggest. Here’s what’s making me cautious about USD/JPY carry positions right now.

The Current Setup

The Federal Reserve is holding rates in the 4-4.5% range. The Bank of Japan is still near zero, despite recent small rate increases. That gives you a 4%+ carry on USD/JPY positions.

When the yen is stable or weakening, that carry turns into attractive total returns. Park money in dollar assets, earn the interest differential, potentially benefit from yen depreciation.

For the last several months, this trade has worked. USD/JPY has traded in a relatively stable range, carry has accrued, and volatility has been manageable.

Why This Could Reverse Quickly

The yen carry trade has a long history of calm stretches followed by violent unwinding. When it reverses, it tends to be fast and painful.

The trigger is usually a rapid strengthening of the yen. This happens when:

• Risk sentiment deteriorates and investors flee to safe havens (yen is a traditional safe haven)
• The Bank of Japan signals actual policy normalization
• Dollar weakness from Fed rate cuts or U.S. economic concerns

When the yen starts strengthening, carry traders using borrowed funds face losses on their currency positions that can exceed months of accumulated interest. That forces position closures, which creates more yen buying, which strengthens it further. It’s a self-reinforcing unwind.

We saw this in 2008, in 2011 after the earthquake, in 2020 during COVID panic, and in 2024 when the BOJ briefly looked like they might normalize policy. Each time, USD/JPY fell sharply and carry positions got crushed.

BOJ Policy Uncertainty

The Bank of Japan is in a difficult position. Inflation is above target, wage growth is picking up, and there’s pressure to normalize policy after decades of ultra-low rates.

But Japan’s economy is fragile. Consumption is weak, debt levels are enormous, and higher rates create fiscal challenges. The BOJ is moving cautiously.

Small rate increases don’t necessarily kill the carry trade if they’re priced in. But if the BOJ signals a genuine policy shift—moving rates meaningfully higher over time—yen would strengthen significantly and carry positions would suffer.

Market expectations for BOJ policy have been wrong repeatedly. Traders have bet on normalization multiple times only to see the BOJ maintain stimulus. But eventually, normalization will happen, and timing it is difficult.

Fed Rate Path

The other side of the carry trade is Fed policy. The current rate differential assumes the Fed stays restrictive while the BOJ stays accommodative.

If the Fed cuts rates faster than expected—because inflation falls, the economy weakens, or financial stability concerns emerge—the carry narrows. Less interest differential means less compensation for the risk of holding USD/JPY.

A scenario where the Fed cuts while the BOJ holds or even raises would compress the carry dramatically. USD/JPY would likely fall both from reduced carry attractiveness and from changing growth expectations.

Valuation Concerns

USD/JPY is well above most long-term fair value estimates. Whether you look at purchasing power parity, real effective exchange rates, or trade-weighted measures, the yen looks undervalued.

Undervaluation can persist for years—it has with the yen. But it creates downside risk. If sentiment shifts or policy changes, there’s more room for yen strength than for further weakness.

Mean reversion isn’t a timing tool, but it’s a risk factor. Being long USD/JPY at 150+ means you’re positioned for the yen to stay weak or weaken further. The probability distribution is asymmetric—more downside potential than upside.

Volatility Is Deceptive

Recent USD/JPY volatility has been low. That makes the carry trade look safe. But yen volatility can spike extremely quickly.

Low volatility encourages borrowing—if the currency is stable, you can borrow more to amplify returns. But when volatility spikes, positions using borrowed funds become unmanageable.

The risk isn’t gradual losses you can manage. It’s gap moves when the yen jumps 2-3% in a session during risk-off events. Stop losses don’t help when the market gaps through them.

Who’s On the Other Side

Major carry trades create crowded positioning. When lots of market participants have the same position, unwinds are messy.

USD/JPY carry is popular with retail traders, hedge funds, and institutional investors. Position data suggests substantial long USD exposure and short yen exposure across market participants.

Crowded trades are dangerous because everyone tries to exit simultaneously when conditions change. Liquidity disappears, spreads widen, and you can’t get out at prices you expect.

Historical Pattern Recognition

The yen carry trade has gone through multiple cycles:

• Works for extended periods with steady returns
• Attracts increasing participation as it keeps working
• Reverses violently during risk events
• Everyone swears they’ll never do it again
• After calm returns, the trade rebuilds

We’re in the phase where the trade is working and participation is growing. That’s historically closer to the end of the cycle than the beginning, though timing is unpredictable.

Alternative Perspectives

Some traders argue the structural case for yen weakness is intact. Japan’s demographics, debt levels, and need for BOJ accommodation mean genuine policy normalization is unlikely.

The counter-argument is that Japan can’t sustain zero rates forever. At some point, inflation pressures, wage growth, or external pressure will force normalization.

Both views have merit. The question is timeframe and positioning. If you’re a long-term macro investor with conviction, the yen carry trade might make sense despite risks. If you’re tactical and risk-sensitive, the setup looks less attractive.

Risk Management

If you’re running USD/JPY carry positions, the key is position sizing and not over-leveraging.

The carry is maybe 4% annualized. If you’re using significant borrowed funds to amplify that to 15-20% returns, you’re exposed to large losses from modest yen strength.

Stop losses are problematic because of gap risk, but position limits help. Decide how much you’re willing to lose if the trade reverses and size accordingly.

Hedging can reduce risk but also reduces returns. Put options on USD/JPY or safe-haven positions elsewhere in the portfolio provide protection but cost money.

Monitoring BOJ and Fed communications is essential. Policy surprises drive the biggest carry trade reversals.

March 2026 Specific Factors

Right now, market focus is on U.S. inflation data and Fed rhetoric. If inflation stays sticky, the Fed keeps rates higher, and the carry remains attractive.

But if growth slows more than expected or financial stress emerges, rate cut expectations will increase. That would pressure USD/JPY and potentially trigger carry unwinds.

Geopolitical risks—U.S.-China tensions, regional instability—tend to benefit the yen as a safe haven. These risks haven’t gone away.

Japanese fiscal year-end flows (March 31) can create temporary yen strength as companies repatriate funds. This is usually small and temporary, but it can amplify moves if other factors are also pushing the yen higher.

Bottom Line

The USD/JPY carry trade is generating positive returns right now, but the risk-reward looks poor for new positions. You’re getting 4%ish carry while exposed to potentially much larger losses if the trade reverses.

If you’re already in carry positions, consider reducing size or hedging. The setup that worked for the last few months won’t necessarily work for the next few.

If you’re thinking about entering new carry trades, think carefully about whether 4% annual return is adequate compensation for the risks. In stable markets, it looks fine. In volatile markets, it can turn into significant losses very quickly.

Carry trades work until they don’t. With USD/JPY, the “don’t” phases tend to be sudden and painful. That doesn’t mean the trade will reverse tomorrow, but the probability of reversal seems higher than the probability of significantly better returns from here.

Position accordingly.