Hedge funds pare yen shorts as carry trades face squeeze

Hedge funds and other leveraged investors have reduced short yen positions after the Japanese currency rallied more than 2% and markets raised the odds of near-term Bank of Japan rate increases. The adjustments have increased volatility in currency and rates markets and triggered defensive trading flows.

The yen climbed over 2% against the dollar to a one-month high and held most gains into Friday. A major dollar spot index fell to its weakest level since May and was set for a weekly decline of about 0.7%. Traders lifted the probability of a 25-basis-point BOJ move at the Sept. 18 meeting and priced in further hikes through next year.

Options and futures activity showed evidence of repositioning. Trading in dollar-yen call options expiring this month was more than 2.5 times that of puts, a pattern consistent with buyers seeking protection against additional yen appreciation and managers covering short-yen exposure. Japanese two-year government bond yields rose roughly 14 basis points over the week.

Swap markets price a 25-basis-point BOJ increase in September and imply almost three further 25-basis-point moves by next July. One analyst group flagged an extreme scenario in which the central bank could deliver three consecutive hikes through December if policy pressure intensifies.

Carry trades, which involve borrowing in low-yielding yen and investing in higher-yielding assets abroad, became more costly as the yen strengthened. Higher-yielding currencies including the Brazilian real, South African rand and Mexican peso each fell by more than 1% against the yen on Thursday as those positions were squeezed.

Positioning data point to a notable unwind. Commodity Futures Trading Commission figures show leveraged funds held a net short yen position of 81,619 contracts in the week ended Aug. 25, while asset managers were net short 18,284 contracts. The same data indicated speculative traders held about $27.6 billion of net dollar longs in the week to Aug. 25, down from nearly $50 billion at the end of July.

Market pricing for US policy shifted as well. Investors scaled back the likelihood of a Federal Reserve rate increase at the Sept. 16 meeting, assigning roughly even odds to a hike. Fed Governor Christopher Waller noted further progress on inflation, and those comments contributed to selling pressure on the dollar. Upcoming US payrolls and consumer-price data are expected to influence Fed path expectations and currency flows.

Corporate flows also affected the market. Reports indicate some Japanese exporters increased dollar sales, exchanging dollars for yen and adding to yen demand.

Market participants note several drivers behind the selling of short yen positions: rising volatility in FX and rates, expectations of faster BOJ tightening than previously anticipated, active dollar sales by exporters and protective flows from leveraged investors. A major bank observed that the yen’s advance appears linked to a broader reduction in risk appetite and added that a clearly stronger signal from the BOJ would be required to prompt a lasting repricing of yen-funded carry strategies.

Swap and options markets continue to reflect the possibility of further BOJ tightening and continued short covering, while macroeconomic data and central bank signals remain key for how positioning evolves in the weeks ahead.