A recent study by Morgan Stanley highlights an unusual development in the foreign exchange and bond markets: the Japanese yen is weakening while Japanese government bond (JGB) yields are rising, disrupting the traditional logic where narrowing interest rate differentials lead to capital repatriation and yen strength. The analysis suggests that speculative carry trades, changing fiscal expectations, and the global macroeconomic environment are collectively shaping the current market structure.

The relationship between the yen and JGBs appears to have reversed. Recent market trends show that yen depreciation is occurring alongside rising JGB yields, contrary to the previous pattern where yield increases typically strengthened the yen. Capital flow data does not indicate a significant return of domestic Japanese investors to JGBs, even though relative yields have improved.

From a capital behavior perspective, Japanese investment trusts continue to allocate to overseas assets, reflecting household sector demand for hedging against inflation and yen depreciation. Life insurance companies, meanwhile, are reducing allocations to both foreign and domestic bonds, instead increasing overseas mergers and acquisitions and direct investments. Due to the separate management of yen and foreign currency balance sheets within the banking system, there is no inherent mechanism for significant "capital repatriation."

Although some foreign investors purchasing Japanese stocks generate periodic yen buying, overall, the recent yen weakness is not primarily driven by securities investment flows.

Speculative short selling and carry trades have become key drivers. The report identifies speculative short positions, particularly during London and New York trading hours, as the main factor behind the recent yen weakness. While CFTC data does not fully capture the scale of carry trades, it still shows leveraged funds continuously building short yen positions. BIS banking statistics and over-the-counter derivatives data also point to a resurgence in carry trade activity.

The market also perceives that Japanese fiscal policy may become more expansionary, leading investors to price a higher risk premium into the yen. Simultaneously, yen depreciation is pushing up inflation expectations and exacerbating concerns that the Bank of Japan (BOJ) is normalizing policy too slowly, resulting in higher term premiums being factored into medium- to long-term JGB yields.

However, as speculation grows that Japan's Ministry of Finance might intervene in the currency market, potentially in coordination with the United States, the expected returns from yen carry trades have begun to decline.

Investors interpret yen weakness through the lens of several converging macro themes, primarily fiscal pressures, the return of inflation, and global demand for carry trades. Firstly, fiscal issues are becoming a long-term theme for developed economies. Debt and deficit levels remain high, while political will for fiscal sustainability is limited. Similar rises in risk premia have been observed in the UK and France; the widening term premium in the Japanese bond market is seen as an extension of this logic.

Secondly, the global inflation landscape has shifted post-pandemic. Some investors view the return of inflation in Japan as a result of the BOJ's prolonged easing policies "working," but it also implies lower real interest rates, thereby reducing the yen's appeal. Some believe BOJ policy remains accommodative, and yen weakness reflects expectations that the central bank is "behind the curve."

Thirdly, demand for global FX carry trades has rebounded. With lower USD volatility expected in the second half of 2025, carry trades have re-emerged as a key strategy, maintaining pressure on the yen as a funding currency.

Why haven't rate hikes and rising yields supported the yen? Conventional logic suggests that rising Japanese interest rates should attract capital inflows and strengthen the yen, but this has not materialized. Pension funds are one of the few institutional groups showing recent rebalancing flows back to Japan, but this is mainly portfolio rebalancing rather than active allocation changes. Investment trusts continue their overseas asset allocation, and life insurers, affected by declining sales of savings-type products, actually have less investable funds. The report concludes that the narrative of "Japanese investors massively selling foreign assets to repatriate funds" is significantly overestimated by the market.

Conversely, foreign investors have become an important marginal source of funding for the Japanese bond market, particularly in the super-long-term JGB sector. Because hedged returns remain attractive, foreign inflows are somewhat supporting bond demand.

The direct causes of recent yen weakness are most pronounced during London and New York trading hours, indicating a greater influence from speculative short selling. The USD/JPY rate has persistently traded above model-estimated "fair value," primarily reflecting two factors: a rise in the US dollar term premium, and increased yen risk premium due to Japanese political uncertainty and expectations of fiscal expansion.

Furthermore, strong US economic performance and delayed expectations for Fed rate cuts are prolonging the period of wide US-Japan interest rate differentials, further enhancing the appeal of carry trades.

Carry trades could potentially unwind if market conditions change. Potential catalysts include rising geopolitical risks, a weakening US economy, or reduced concerns about Japanese fiscal expansion. Additionally, markets are beginning to factor in the risk of currency intervention. Recent "rate checks" by Japan's Ministry of Finance and perceived coordination with US authorities are interpreted by some investors as signals of potential coordinated intervention.

Simultaneously, markets have started pricing in a possibility that the BOJ might accelerate its pace of rate hikes, with the probability of an April hike now estimated at 70-80%.

A tail risk scenario suggests USD/JPY could fall back towards 145. In summary, if global risk sentiment weakens, fiscal expectations improve, or intervention fears intensify—even if only one of these factors materializes—it could trigger a broader unwinding of carry trades. The report suggests that in such a scenario, USD/JPY could potentially fall back to around 145, closer to its model fair value, at least on a temporary basis.