Yen Carry Trade Reversal Unlikely Despite Rising Bond Yields, UBS Says

A major reversal of the popular yen carry trade remains highly unlikely despite a recent surge in Japanese government bond (JGB) yields, according to an October 14 research report from UBS. The bank's strategists assigned a "very low probability" to a significant unwinding of yen-funded investments, arguing the trade's appeal persists.

The yen carry trade involves borrowing in Japan's low-interest-rate currency to invest in higher-yielding assets overseas. A large-scale reversal could disrupt global markets by forcing investors to sell foreign assets and buy back yen.

Rate Differentials Remain Key

Concerns over the carry trade's stability have grown following a sharp sell-off in JGBs, which has pushed yields up by approximately 140 basis points over the past two months, UBS noted. However, the report highlights that government bond yields have also risen globally, preserving the wide interest rate differentials that underpin the strategy's profitability.

While markets anticipate further tightening, UBS's Japanese macroeconomic team forecasts that the Bank of Japan's interest rates will peak around 2% within 12 months. The bank expects the yen to remain a weak currency, which would continue to support the carry trade.

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Emerging Market Exposure

Should Japanese investors begin to repatriate capital, certain emerging markets could face disruption. UBS identified several markets with relatively high Japanese equity ownership compared to their market capitalization, which could expose them to shifting investment flows.

• High Japanese ownership: The United Arab Emirates, Singapore, Australia, South Africa, and India.
• Historically sensitive to JGB yields: Korean and Brazilian equities have shown particular sensitivity to rising Japanese bond yields.
• Potential outperformers: In contrast, equities in South Africa, Korea, and Thailand, as well as materials stocks, have historically tended to outperform during periods of yen appreciation.

Despite these risks, UBS maintained a constructive outlook on emerging-market equities. The bank cited strong earnings growth and more reasonable valuations following a recent sell-off as reasons for its positive stance, identifying Korea, Brazil, and China as its preferred markets.