The yen arbitrage trading - an investment strategy that caused significant market turbulence this year - is regaining favor.

According to Bloomberg's analysis of data from the Japan Financial Futures Association, the Tokyo Financial Exchange, and the US Commodity Futures Trading Commission (CFTC), the bearish bets on the yen by Japanese retail investors, as well as overseas leveraged funds and asset management companies, are expected to increase from $9.74 billion in October to $13.5 billion in November.

It is expected that these bets will further increase next year due to the large interest rate gap, increased US government borrowing, and lower volatility in the money market. These conditions make borrowing in Japan and investing funds in markets with higher global returns more attractive.

The significant interest rate differential compared to the Japanese yen means that it will always be considered a financing currency, "said Alvin Tan, Head of Asia Forex Strategy at Royal Bank of Canada Singapore. The main reason why the Japanese yen cannot be used for arbitrage trading is volatility

Strategists from Mizuho Securities and Shengbao Market suggest that arbitrage trading may return to levels seen earlier this year, when investors abruptly exited due to the Bank of Japan's July interest rate hike. But a potential uncertain factor is that Trump's return to power may cause turbulence in the currency market.

Speculators begin to re-establish short positions in the Japanese yen

The data shows that the widespread adoption of this investment strategy may have an impact on the global market. The closing of arbitrage trades this summer caused the global stock market to evaporate about $6.4 trillion in just three weeks, and the Nikkei 225 index suffered its largest decline since 1987. The sudden surge of the Japanese yen last week highlighted the ongoing risks faced by investors who have re entered this trade.

The interest rate spread is a key factor driving this transaction. The average yield of 10 major currencies and emerging market currencies with high yields exceeds 6%, while the benchmark interest rate of the Bank of Japan is only 0.25%, and the yield of the Japanese yen is almost negligible.

Although the Bank of Japan is gradually raising interest rates, the yield gap with major economies such as the United States remains significant. Felix Ryan, a foreign exchange analyst at ANZ Bank in Sydney, stated that the Federal Reserve lowered its benchmark interest rate by 0.25 percentage points in November to a range of 4.5% -4.75%. Even if Japan raises interest rates to around 1%, the logic of arbitrage trading still holds true.

This strategy has a huge profit margin. The arbitrage trading conducted in Japanese yen as the financing currency against 10 major and emerging market currencies has achieved a return rate of 45% since the end of 2021, compared to a return rate of 32% for the S&P 500 index including reinvestment dividends. This attracted more and more investors, and by the end of July, the short position in the Japanese yen had reached $21.6 billion, followed by severe fluctuations due to liquidation.

"The interest rate increase by the Bank of Japan may not be enough to narrow the income gap between Japan and the United States," said Charu Chanana, chief investment strategist of Sempo Market

The yield of the Japanese yen is still far lower than other currencies

With Trump's tariffs and tax cuts potentially boosting the economy and inflation, the US dollar and US yields have surged recently, which could slow down the pace of the Federal Reserve's interest rate cuts. However, Shoki Omori, head of Japan research strategy at Mizuho Securities in Tokyo, said that Trump's decision to nominate Scott Bessent as Treasury Secretary slightly eased market concerns. Nevertheless, Trump still dominates the fiscal policy of the United States.

Everything is related to Trump, "Omori said. He believes that arbitrage trading may make a comeback as early as January. The outside world underestimated Trump's influence on Bessent. If Bessent wants to stay in this position, I don't think he will be too persistent on budget issues

The Trump administration's threat of a trade war may also put pressure on global assets, especially after Trump promised to impose more tariffs on China, Canada, and Mexico last week. Although the Mexican peso has long been the preferred currency for yen arbitrage trading due to the country's double-digit interest rates, Trump's remarks may cause enough volatility to make this trade lose its appeal.

This is important because yen arbitrage trading benefits from the low volatility of the currency market. Despite the uncertainty brought by the new Trump administration and the escalation of the war in Ukraine, JPMorgan's foreign exchange volatility index has fallen from post pandemic highs.

However, some people believe that the narrowing of interest rate spreads will weaken the momentum of arbitrage trading next year, especially after Bank of Japan Governor Kazuo Ueda hinted at a possible interest rate hike in December. Japanese officials have also expressed concerns about the yen, with the Finance Minister mentioning last month that there have been rapid unilateral fluctuations in the exchange rate since the end of September.

The Ministry of Finance has re engaged with speculators through verbal intervention, and Governor Ueda's words continue to raise concerns about the Bank of Japan's interest rate hike in December, "said Jane Foley, head of foreign exchange strategy at Rabobank. Although arbitrage trading is gaining more support, "this may lead to a lack of confidence and momentum in arbitrage trading during the spring season

Investors may receive further clear guidance on arbitrage trading at the Bank of Japan and Federal Reserve meetings in December. Ueda Kazuo adopting a more dovish tone or Federal Reserve Chairman Jerome Powell adopting a more hawkish tone, as well as any clues from key data, may pull arbitrage traders back into the market.

The rate hike speed of the Bank of Japan will be very slow, and if Powell does not cut rates quickly, the interest rate spread will still be attractive for arbitrage trading, "Omori said." If the Japanese Ministry of Finance keeps a low profile, investors will feel there is no reason not to engage in such trading.