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Carry trade has become one of the most significant phenomena for understanding the dynamics of international financial markets. It is no longer merely a strategy employed by investment desks or hedge funds but a mechanism capable of influencing global liquidity, foreign exchange markets and capital flows between the world’s major economies.
The system increasingly resembles an engine being pushed beyond its limits, with the rev counter constantly hovering close to the red zone. As long as conditions remain favourable, the mechanism continues to function. However a sudden shift in the monetary regime or a sharp increase in volatility can trigger a rapid unwinding of positions and spread tension throughout the entire financial system.
In a context where central banks no longer act in unison, carry trade primarily highlights the profound divergences between the monetary policies of the world’s major economies.
What carry trade is and how it works
The mechanism behind carry trade is relatively simple: an investor borrows money in a country with low interest rates, converts that capital into a currency offering higher returns and invests in the corresponding financial instruments.
The profit primarily comes from the difference between interest rates.
The strategy, however, only works under one fundamental condition: the funding currency must remain relatively stable or weaken against the currency in which the investment is made.
If, on the other hand, the funding currency strengthens rapidly, exchange-rate losses may wipe out the return generated by the interest-rate differential.
The yen and carry trade: the role of Japan
One of the most important examples is the Japanese yen.
For many years, the extremely accommodative monetary policy of the Bank of Japan (BoJ) has kept the cost of borrowing at levels well below those of other major economies.
During the period 2015–2025, the differences were particularly striking:
- Japan – Bank of Japan: interest rates remained around 0% or in negative territory for a prolonged period of time;
- United States – Federal Reserve: rates rose from levels close to zero to 5.50% in 2023;
- Brazil – SELIC: rates experienced significant fluctuations, reaching levels roughly between 6% and 14%.
The gap between Japanese returns and those offered by the United States or various emerging markets created a genuine yield corridor.
For many financial operators, the yen therefore became one of the main currencies used to finance carry trades.
The Yen paradox
Carry trade can contribute to creating a self-reinforcing mechanism.
An investor borrows yen, sells the Japanese currency on the market and purchases a currency offering a higher return. If these transactions become widespread, the selling pressure on the yen can further exacerbate its weakening.
This creates what we might call the yen paradox:
- the more the yen weakens;
- the more attractive the carry trade can become;
- the more capital is encouraged to use the yen as a funding currency;
- the greater the potential pressure on the Japanese currency.
According to an analysis by the Bank for International Settlements (BIS), the yen’s role in international funding strategies became particularly significant during periods of sharp divergence in global interest rates.
In the two-year period 2024–2025, the Japanese currency also reached significantly weak levels against the US dollar, at times exceeding 160 yen to the dollar.
The BoJ’s monetary policy and the wide differential with US interest rates were two of the main factors underlying this trend.
How much can carry trade return?
The return generated by carry trade primarily depends on three elements:
- the interest rate differential;
- exchange rate trend;
- financial market volatility.
When these conditions remain favourable, the strategy can generate attractive returns.
Studies by the International Monetary Fund (IMF) have analysed how, during periods characterized by low volatility, carry trade strategies involving major currencies can yield significant returns.
The potential return also tends to increase when the strategy is applied to currencies of emerging economies characterised by particularly high interest rates.
What makes carry trade attractive, therefore, is not simply the nominal return but the ratio between the return and the risk during favourable market conditions.
And this is precisely where the problem lies.
Carry trade and risk: when the strategy implodes
In the financial world, carry trade is sometimes described using a particularly apt expression: “picking up pennies in front of a steamroller.”
Over long periods, the strategy can generate relatively steady returns. However, when volatility suddenly spikes, the trend can reverse extremely rapidly.
Investors begin closing their positions simultaneously, selling the assets they have purchased and buying back the currency used for financing.
The result can be a sudden strengthening of the funding currency and at the same time place downward pressure on the assets purchased using leverage.
Carry trade and financial crises
Financial market history provides several examples of the risks associated with reversing these strategies.
The 1997 Asian Financial Crisis
During the Asian financial crisis, many positions built by exploiting return differentials between Japan and emerging economies suffered heavy losses.
The collapse of Asian currencies rapidly changed the risk-return profile of these trades, forcing many investors to liquidate their positions.
The 2008 Financial Crisis
An even more striking phenomenon occurred during the global financial crisis.
At the height of the flight toward assets perceived as safer, the yen strengthened rapidly. Traders who had financed international investments through yen-denominated loans were consequently forced to close their positions.
The carry trade crash risk
The Bank for International Settlements identifies one of the strategy’s main dangers as the so-called crash risk.
The concept is simple: small gains accumulated over months or years can be wiped out by a sudden and very sharp movement in the foreign exchange market.
The risk becomes particularly high when many investors adopt the same strategy simultaneously.
At that point, the problem no longer concerns just a single fund or investor but can turn into a systemic phenomenon.
Carry trade as a market barometer
Carry trade can be regarded as a genuine barometer of global finance.
When it thrives, it generally means that:
- volatility is low;
- investors have a high appetite for risk;
- liquidity is abundant;
- the search for return is particularly intense.
When, on the other hand, carry trade begins to unwind rapidly, it may signal the onset of a completely different phase.
A sudden unwinding can in fact accompany liquidity crises, currency shocks, sharp corrections in financial markets or changes in expectations regarding monetary policy.
For this reason, the performance of major carry trade strategies can become a true barometer of global confidence.
Monetary policies and global imbalances
A boom in carry trades also highlights a structural issue: the growing asynchrony of monetary policies.
When a major economy keeps interest rates significantly lower than the rest of the world for an extended period, investors can exploit this divergence to finance international transactions.
This phenomenon can generate enormous capital flows, affecting not only currencies but also bonds, equities and emerging markets.
Japan is one of the most striking examples.
Years of extremely accommodative monetary policy have transformed the yen into one of the major sources of funding for the international financial system.
The problem arises when monetary policy changes.
Even a relatively modest shift in expectations regarding the Bank of Japan’s interest rates can suddenly make carry trade less attractive, prompting investors to close their positions simultaneously.
Why carry trade matters for the global economy
Observing carry trade therefore means looking beyond the foreign exchange market alone.
This strategy enables us to understand where international liquidity is flowing, which economies are being used as sources of funding and which markets are attracting the greatest amount of speculative capital. Above all, however, it helps identify the vulnerabilities within the system.
In a balanced market, carry trade should represent just one of the many strategies employed by investors. When, however, it becomes large enough to influence currencies, bonds and global markets, it becomes a signal of much deeper imbalances.
Carry trade is therefore not merely a financial strategy. It is one of the most interesting indicators in understanding the direction of global liquidity, risk perception and the divergences between the world’s major central banks.
Sources and further reading
- Bank for International Settlements – Carry Trades and Global Liquidity
- Financial Times – Yen Weakness and Speculative Flows
- IMF Working Paper – Currency Carry Trades: Risks and Returns
- Federal Reserve Bank of New York – The Economics of Carry Trade
