But appetite was much weaker for European indices, as a further rally in energy prices (especially European gas prices), an unexpected contraction in German industrial production in July and mixed Euro area growth updates weighed on Europe’s tech-poor, cyclical-sector-heavy indices, as the ECB prepares to deliver a 25bp rate hike this Thursday to tame the Middle East-led spike in energy prices – hoping to cool inflationary pressures that don’t even depend on its policy.

The EURUSD advanced slightly, but the move was mostly driven by a broader retreat in the US dollar – as a rate hike from the ECB this week is almost entirely baked into the euro’s valuation. The dollar, on the other hand, softened as the early spike in crude faded, and the Japanese yen appreciated by a big chunk on expectations that rising Japanese bond yields are now able to convince big Japanese institutional investors to repatriate funds back home.

The 10-year JGB has retreated below the 2.90% mark (after hitting the 3% earlier this month), and that’s more than a full percentage point above the levels once considered as being a potential trigger for the big Japanese institutions for bringing money back home. We’re talking about potentially tens of billion dollars of Japanese institutional money, coming back home, potentially leaving the US Treasuries.

US bond markets returned from Monday’s break with a slight rebound, but worries about a potential carry-trade unwind have not eased.

If the Bank of Japan (BoJ) hikes rates this month — and lays out a framework for further normalisation, which may be the only way to sustain the yen’s latest rebound — and if the Fed remains silent amid political pressure that will likely become unbearable into the November midterm elections, the risk of a yen carry-trade unwind will become louder. That means we could see the Japanese yen strengthen further, US Treasury yields rise and global equity indices fall in a rapid move.

What happens during a yen carry unwind?

The last major yen carry-trade unwind was in late July/early August 2024. The trigger was a nasty combination of the BoJ raising rates (and signalling further normalisation), the yen appreciating sharply, and weak US employment data suddenly increasing expectations of Fed cuts. The sour cocktail of all these factors compressed the US-Japan rate differential from both sides and forced leveraged investors to unwind yen-funded positions.

As a result, the USDJPY fell more than 13% between mid-July and mid-September, and the S&P500 dropped nearly 10% compared with its prior peak. The good news is that the shock dissipated very quickly. It took the S&P500 about two weeks to recover all losses and continue its journey up, while the Japanese yen swung between gains and losses, and eventually started its persistent fall in early 2025, bringing us to today, where the Japanese alone can no longer stop the bleeding without US help – and, more importantly, without adjusting policy rates to economic fundamentals. No, you can’t have inflation at 2% and a policy rate half of that.

So, the question is: what would happen in a renewed episode of yen carry-trade unwinding today?

Today, the story is the same on the BoJ front – we’re still waiting for the BoJ to normalise. The Federal Reserve (Fed) side is slightly different. The Fed should tighten its policy to tame inflation, but we’re unsure how much tightening it could do given the political pressure, and how Fed policy could impact US yields when the US Treasury is also interfering with longer-term bond yields by increasing the size of its bond buybacks.

But if US longer-term yields top – somehow – and the BoJ moves ahead with rate hikes, the US-Japan rate differential could compress enough to trigger a carry unwind. The latter could be especially painful for the AI/tech complex, where high valuations and crowded positions could amplify a potential selloff. I would say that the latter would open the door to dip-buying opportunities, as a period of carry unwind doesn’t last forever... But in the short run, for a couple of weeks, investors would be feeling the heat.

That’s the equities side of the story. But there is another interesting angle to the yen-funded carry story. The AUDJPY is one of the classic yen carry trades, where investors borrow cheaply in yen to invest in higher-yielding Australian assets. If you want a powerful carry trade, you go to the AUDJPY. And the pair hit a record high this year, trading near the 115 mark since May, supported by hawkish Reserve Bank of Australia (RBA) expectations and a persistently dovish BoJ.

That trade also looks vulnerable today, as the pair has plenty of room to retreat — and carry-trade unwinds tend to happen very rapidly. So caution on that front. The AUDJPY would probably be one of the major casualties if a yen carry-trade unwind unfolds.

Looking beyond the yen carry story...

If we dive into the Aussie, the outlook has been improving. The AUDUSD, for example, spiked past 72 cents yesterday and the pair is now approaching its May peak — which marked its highest level since 2022. Part of the explanation may be due to hawkish RBA expectations and the broader debasement trade, but another part may be that the commodity-market proxy most relevant to the Aussie story is changing.

The Aussie has historically been a good proxy for iron ore and captured China’s property-boosted growth story quite well. Today, iron ore is under pressure because China demands less steel amid its property crisis, while supply from Africa, Brazil and Australia is expected to weigh further on prices.

But copper traders are coming to the rescue by increasingly using the Aussie as a proxy for copper/global commodity demand — demand driven not only by China, but by electrification, power grids, renewable infrastructure and, increasingly, AI and data-centre investment around the globe. Copper hit a record high on the LME yesterday (on expectations that the US would expand tariffs to refined copper imports). Australia’s government expects copper export earnings to rise from A$14.6bn to A$18.3bn in real terms by 2030–31.

Now, it’s important to note that Australia’s copper exports remain well below iron ore exports (around A$117bn today), but rising interest in copper could be supportive of the Aussie against many majors. As such, the broader macro themes of today could result in an interesting divergence in FX: a yen carry-trade unwind could weigh heavily on AUDJPY, while the RBA and copper story could offer the AUDUSD some relative support — at least as long as the carry unwind doesn’t morph into a broader risk-off move.

Moving forward, investors will be watching the US return from its Monday holiday, the US Treasury starting to buy more US bonds, US inflation, Japanese rate policy intentions into next week’s meeting and stress levels regarding the mounting risk of a yen carry-trade unwind across global markets, before deciding where markets should be heading next.

There are certainly many uncertainties in the market today, but that also means a good amount of opportunities that investors could capture over the next few weeks.