Japan's 10-year government bond yield pierced the 3% threshold this week, marking its highest level in nearly three decades and sending shockwaves through global financial markets.

This critical milestone, combined with a persistently weakening yen and rising expectations of Bank of Japan rate hikes, has dramatically heightened concerns over a large-scale unwinding of yen carry trades. US Treasury Secretary Scott Bessent has publicly warned that disorderly moves in the yen market could trigger forced liquidations, potentially destabilizing global markets and ultimately driving up borrowing costs for American households and businesses.

Currently, markets have fully priced in a 25-basis-point rate hike by the Bank of Japan in September—a pace far more aggressive than the central bank's own guidance earlier this year.

Why Did Yields Break Through 3% Now?

The 10-year Japanese government bond yield climbed above 3% on Tuesday, a level not seen since September 1996. This move is not an isolated event. Global bond markets are under widespread pressure as investors recalibrate inflation expectations and anticipate further tightening by major central banks. However, traders and economists believe Japan's situation warrants particular attention.

The Bank of Japan has already ended decades of ultra-loose monetary policy, and market consensus suggests its key policy rate—currently at 1%—will continue to rise. Meanwhile, the yen's persistent weakness and accelerating inflation are adding further pressure on the central bank to quicken its tightening pace.

Policy dynamics are also contributing to the strain. US Treasury Secretary Bessent has explicitly stated he expects BOJ Governor Kazuo Ueda to raise rates as early as this month. Additionally, Prime Minister Sanae Takaichi's administration has openly favored expanding fiscal stimulus, raising investor concerns about Japan's fiscal sustainability—a factor behind both the yen's depreciation and the upward pressure on government bond yields.

Carry Trade: How Large Is It, and How Risky?

The yen carry trade operates on a simple premise: borrow yen at ultra-low interest rates and invest in higher-yielding assets. This strategy flourished during Japan's prolonged period of ultra-low rates. When the BOJ raised its policy rate to 0.25% two years ago, markets experienced severe turbulence, widely attributed to the abrupt unwind of carry trade positions.

According to reports cited by analysts, carry trade positions have accumulated substantially since 2024. Osamu Takashima, a forex analyst at Citi, noted that "hedge funds and other short-term investors have been shorting the yen against the US dollar while simultaneously going long high-yield currencies like the Mexican peso."

Analysts at Capital Economics cite data showing that by early August this year, Japan's outstanding loan balance to overseas borrowers had already surpassed its 2024 peak. Furthermore, loans from foreign bank branches in Tokyo to their headquarters have reached their highest level since the global financial crisis.

The latest global fund manager survey by Bank of America reveals that "shorting the yen" remains one of the three most popular trades worldwide. However, most analysts believe the risk of a large-scale, sudden carry trade unwind remains manageable at present. Kamakshya Trivedi, chief FX strategist at Goldman Sachs, stated that yen-funded carry trades this year are more resilient than during the 2024 intervention period, noting that a "structural unwind" would require Japanese investors to repatriate funds from overseas assets en masse. He added: "Currently, there is almost no sign in official portfolio flow data that this rotation has occurred."

James Lord, global head of FX strategy at Morgan Stanley, echoed this view, noting that Japanese investors are still "significantly purchasing" US assets. "We have not yet seen a meaningful repatriation of Japanese funds into domestic assets," he said.

US Treasuries and Global Markets: Japan as the Largest Foreign Holder

Japan is the largest foreign holder of US Treasuries, with holdings exceeding $1 trillion, predominantly concentrated among financial institutions. As domestic yields rise, concerns are growing that Japan's major pension funds and life insurance companies—institutions already sitting on tens of billions of dollars in paper losses on their bond portfolios—may shift investment strategies and rotate funds back home.

Naka Matsuzawa, a rates strategist at Nomura, said Thursday's 30-year Japanese government bond auction would be a key signal for whether this shift has begun. "If life insurers participate actively in the auction, it could easily trigger market speculation that some capital is flowing back from overseas to Japanese assets."

Takashima at Citi noted that life insurers have been waiting for the 20-year JGB yield to reach 2.5%–3% but have yet to enter in force due to concerns about further price declines. "If they perceive that downside risk has peaked, we could see larger capital flows," he said.

Bank of Japan: September Rate Hike Nearly Certain, October Possibility Emerges?

Markets have fully priced in a 25-basis-point BOJ rate hike in September—a pace far more aggressive than the central bank's initial signaling. Economists believe this move is partly coordinated with the government's broader efforts to support the yen.

More notably, some market participants are now positioning for a potential additional hike in October. Hajime Takata, a hawkish member of the BOJ's policy board, said in a speech on Wednesday that a 25-basis-point increase is "not set in stone," emphasizing that "the environment has changed." Governor Ueda separately indicated that the central bank would discuss interest rates at all upcoming meetings.

Despite this, the yen remains weak, hovering around 160 per US dollar. Joint interventions by Japanese and US authorities in July and August had significantly boosted the currency, but more than half of those gains have since been erased. Analysts partly attribute the yen's continued softness to rising equity markets—foreign stock investors typically hedge exposure by shorting the yen, and as stocks rally, they are compelled to expand their short positions.