Arbitrage of Japanese Yen on the cliff edge! The USD/JPY exchange rate approaches the 140 support level, causing the interest rate differential to narrow or trigger a wave of liquidation.

The yen carry trade is teetering on the edge of a cliff. Since the summer of 2023, the USD/JPY exchange rate has consistently remained above the 140 level, but the current pressure from expectations of a rate hike in Japan and downward pressure on interest rates in the United States could be the "last straw" that breaks this two-year carry trade pattern. If the USD/JPY plunges significantly, the yen's appreciation could trigger a chain reaction in global asset allocation. The current market is in a delicate balance: Japan's inflation rate has remained higher than the central bank's target, with second-quarter GDP growth at 1% far exceeding market expectations. Additionally, weak U.S. nonfarm data, combined with President Trump's calls for rate hikes, have put the Federal Reserve in a dilemma. Japan's central bank is criticized for being "slow to act", and U.S. Treasury Secretary Benson's statements highlight the pressure of policy differentiation. Japanese bond yields skyrocket while spreads are under pressure Against this backdrop, Japan's 10-year government bond yields have surged between 2024 and 2025, now nearing the technical resistance level of 1.58%. This level was last seen in 2008 and has been tested multiple times in recent months. If this resistance level is successfully broken, it could trigger a chain reaction: on one hand, Japanese bond yields could rise further to 1.86%; on the other hand, the spread between U.S. and Japanese 10-year government bond yields could significantly narrow. Specifically, the spread between the U.S. 10-year government bond yield and the Japanese government bond yield (U.S. bond yield minus Japanese bond yield) has been fluctuating in the range of 2.75%-2.8% since September 2024, facing another test. It is worth noting that this spread trend has formed a "descending triangle" technical pattern and if it breaks the support level, it may further decline to around 2.3%. Historically, the USD/JPY exchange rate has shown a high correlation with the U.S.-Japan 10-year government bond yield spread, but there has been a recent temporary divergence. A similar situation occurred in the summer of 2024, with the exchange rate eventually falling back in line with the spread trend. Current market analysis suggests that this divergence may happen again. The USD/JPY exchange rate is approaching the critical point of unwinding at 140 It is important to note that there has been a recent crack in the historical correlation between the USD/JPY exchange rate and the U.S.-Japan spread. A similar divergence occurred in the summer of 2024, with the exchange rate eventually falling back in line with the spread. The current market is betting on a "historical replay". Of even more concern is the 5-year USD/JPY cross-currency basis swap, which has formed a "rising triangle" bullish pattern, indicating a decreasing cost of hedging USD for Japanese investors with USD assets. This poses a double pressure for Japanese investors holding USD assets: they have to bear the exchange losses due to the appreciation of the yen and face the declining returns due to the shrinking hedging premium. From a technical standpoint, the USD/JPY exchange rate is approaching the key support level of 140. If this level is breached, it could trigger large-scale unwinding of carry trades - since July 2023, carry trade demand has been supporting the USD/JPY exchange rate above 140. In conclusion, although the correlation between the yen's strength and the Nasdaq 100 index is weaker than last year, historical experience shows that heightened risk aversion often accompanies a yen appreciation. After numerous tests in interest rates and currency markets at key resistance levels, the market generally expects that this two-year carry trade feast may come to an end sooner than most people anticipate.