The uncertainty in Japan's political situation and monetary policy has rekindled interest in yen arbitrage trading

According to Zhitong Finance APP, the yen carry trade, which once collapsed last year, may now become one of the biggest beneficiaries of changes in Japan's political landscape. This strategy is regaining favor among investors—its basic model involves borrowing low-yielding yen and investing in other currencies with higher yields.

In the recent elections, the ruling coalition led by Prime Minister Shigeru Ishiba lost its majority in the Senate. Market participants point out that this election result has revitalized the yen carry trade. Investors believe that this situation may force Ishiba's government to increase fiscal spending to gain support from opposition parties, while political uncertainty may also prompt the Bank of Japan to slow down the pace of interest rate hikes—both of these factors are unfavorable for the yen, thus supporting the yen carry trade.

Freddy Wong, Head of Fixed Income for Asia Pacific at Invesco, stated: "Although Ishiba has indicated that he will continue to govern, speculation and pressure regarding his potential resignation are intensifying." He pointed out that changes in the political landscape and uncertainties surrounding U.S.-Japan tariff negotiations may also lead the Bank of Japan to delay interest rate hikes, which would be favorable for the yen carry trade.

Reports indicate that before U.S. President Trump announced a trade agreement with Japan, Ishiba had stated that his political fate was tied to the progress of tariff negotiations. The latest reports suggest that Ishiba may announce his intention to resign as early as this month, while other Japanese media expect his resignation to occur next month. Following this news, the yen slightly weakened.

Additionally, Bank of Japan Deputy Governor Shinichi Uchida stated shortly after Trump announced the trade agreement with Japan that there is currently no urgent need to raise the benchmark interest rate.

Since Japan significantly lowered interest rates in the late 1990s, allowing investors to borrow yen at low costs, the yen carry trade has been an important component of the market. Although this strategy faced setbacks after the Bank of Japan began raising interest rates last year, as the market continued to rise under Trump's tariff policies, global funds are once again seeking opportunities to restart the yen carry trade.

This strategy has recently begun to yield substantial returns. Over the past three months, borrowing yen to invest in New Taiwan dollars has generated a 13% return, while similar operations investing in South African rand and Mexican peso have yielded returns of around 10%. This contrasts sharply with the comprehensive losses experienced in these trades in the third quarter of last year.

While it is difficult to accurately measure the scale of funds in the yen carry trade, existing data indicates that this strategy is regaining popularity. According to the latest data from the Commodity Futures Trading Commission (CFTC) for the week of July 15, hedge funds have turned bearish on the yen for the first time in nearly four months. Meanwhile, over the past three months, the yen has depreciated against all major currencies.

One key reason for the collapse of the carry trade in August last year was the Bank of Japan's unexpected interest rate hike, but given the uncertainty surrounding Prime Minister Ishiba's position, the likelihood of this situation occurring again now seems low Go Tanuma, CEO of the Japanese hedge fund Go Fund Inc., stated: "Shinzo Abe may ultimately have to resign. Political turmoil makes it harder for overseas investors to find reasons to buy yen. Therefore, there is still room for yen arbitrage trading in the short term."

One of the long-term fundamentals for yen arbitrage trading remains intact. Although the Bank of Japan has raised interest rates three times since early last year, the current benchmark interest rate in Japan is still only 0.5%, far below the Federal Reserve's federal funds rate of 4.25%-4.50%.

Mark Cranfield, a strategist at Markets Live, said: "Domestic inflation in Japan is a hot issue, which has led the ruling coalition to lose its majority in the Senate, but due to political instability, the Bank of Japan is reluctant to raise interest rates." "For the yen, this is a dilemma, and forex traders will continue to take advantage of this by shorting the yen against G10 currencies."

Asset management company Loomis Sayles & Co. believes that the yen-to-dollar exchange rate could further drop to around 153 yen per dollar, which would support yen arbitrage trading. The company's global macro strategist Bo Zhuang stated: "In the short term, I do not believe the yen-to-dollar exchange rate can hold at the level of 147 or 148 yen per dollar. Amid various uncertainties, yen arbitrage trading may continue to grow."

However, not everyone agrees that yen arbitrage trading is a good long-term strategy. Antony Foster, head of G10 spot trading at Nomura International, stated that holding some yen arbitrage positions during the summer trading lull is reasonable, "but concerns about the Federal Reserve's monetary policy and Trump's pressure on Fed Chairman Powell may put pressure on this strategy in the future."