Yen arbitrage on the edge of a cliff! The USD/JPY exchange rate approaches the 140 support level, and the narrowing interest rate differential may trigger a wave of short covering

According to Zhitong Finance APP, yen arbitrage trading is standing on the edge of a cliff. Since the summer of 2023, the USD/JPY exchange rate has remained above the 140 mark, but the current dual pressure of rising interest rate expectations in Japan and easing pressure in the U.S. may become the "last straw" that breaks this two-year-long arbitrage model. Once the USD/JPY significantly declines, the appreciation of the yen may trigger a chain reaction in global asset allocation.

The current market is in a delicate balance: Japan's inflation rate continues to exceed the central bank's target, with a 1% annualized GDP growth in the second quarter far exceeding market expectations, while weak U.S. non-farm data combined with President Trump's calls for interest rate hikes have put the Federal Reserve in a dilemma. The Bank of Japan has been criticized for being "behind the curve," and U.S. Treasury Secretary Janet Yellen's statements further highlight the pressure of policy divergence.

Japanese Bond Yields Soar, Spreads Under Pressure

In this context, the 10-year Japanese government bond yield has surged significantly between 2024 and 2025, currently nearing a technical resistance level of 1.58%. This level was 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 government bond yields may further rise to 1.86%; on the other hand, the spread between U.S. and Japanese 10-year government bonds may significantly narrow.

Figure 1

Specifically, the current spread between U.S. 10-year government bond yields and Japanese government bonds of the same maturity (U.S. bond yield minus Japanese bond yield) has been oscillating in the range of 2.75%-2.8% since September 2024, and this support level is facing another test recently. Notably, this spread has formed a "descending triangle" technical pattern, and if it breaks below the support level, it may further drop to around 2.3%.

Figure 2

Historically, the USD/JPY exchange rate has shown a high correlation with the U.S.-Japan 10-year government bond spread, but a phase divergence has recently occurred. A similar situation appeared in the summer of 2024, where the exchange rate eventually fell back and realigned with the spread trend. Current market analysis suggests that this divergence phenomenon may repeat again.

Figure 3

The USD/JPY exchange rate approaches the critical point for liquidation at 140

It is noteworthy that the historical correlation between the USD/JPY exchange rate and the USD/JPY interest rate differential has recently shown signs of a fracture. A similar divergence occurred in the summer of 2024, ultimately leading to a convergence of the exchange rate and the interest rate differential, and the current market is betting on "history repeating itself."

Even more concerning is the 5-year USD/JPY cross-currency basis swap, which has formed a "rising triangle" bullish pattern, suggesting that the cost of hedging by borrowing USD is decreasing. For Japanese investors holding USD assets, this creates dual pressure: they must endure exchange losses due to the appreciation of the yen while also facing a decline in returns caused by shrinking hedging premiums.

Figure 4

Technically, the USD/JPY exchange rate is approaching the key support level of 140. If this level is breached, it could trigger large-scale liquidation of arbitrage trades—since July 2023, it has been the demand for arbitrage that has supported the USD/JPY rate above 140.

Figure 5

Summary

Although the current strength of the yen is less correlated with the Nasdaq 100 index than last year, historical experience shows that rising risk aversion is often accompanied by yen appreciation. After multiple tests of key resistance levels in the interest rate and currency markets, the market generally expects that this two-year-long arbitrage feast may come to an end sooner than most anticipate.

Figure 6