The once-reliable strategy of borrowing yen to fund higher-yielding investments is undergoing a fundamental transformation, with the Japanese currency's recent appreciation eroding its appeal as the world's preferred funding vehicle. This shift is prompting global investors to increasingly consider alternatives like the Swiss franc and Swedish krona, a reallocation that could trigger significant volatility across equity, bond, and high-yield currency markets if it coincides with broad deleveraging.

Market dynamics are rapidly evolving as expectations for further rate hikes by the Bank of Japan, coupled with coordinated intervention by Tokyo and Washington to support the yen, have substantially increased the currency risk associated with borrowing yen. A September economist survey revealed widespread predictions that the central bank will raise its policy rate to 1.25% by mid-September, with projections pointing to a multi-decade high of 1.75% by the second quarter of 2027. The changing landscape is already visible in returns, with the classic strategy of selling yen to buy Australian dollars having delivered roughly 9% in the first half of the year but suffering approximately 1.3% losses since July.

The fundamental appeal of carry trades lies in the spread between borrowing costs and asset yields, but an appreciating funding currency can quickly erode those gains by increasing the cost of repaying the borrowed funds. For leveraged investors, this dynamic can force rapid asset sales to meet margin calls, potentially amplifying market-wide selling pressure. Research from the Bank for International Settlements into the August 2024 market turmoil highlighted how leveraged position unwinding and increased margin requirements exacerbated the financial shock.

As the yen's funding advantage diminishes, a competition among potential successor currencies has emerged, with each candidate presenting its own unique set of opportunities and risks. Notably, major asset managers are expressing divergent views on which currency will ultimately gain favor.

Swiss Franc Emerges as Leading Contender

Among the candidates, the Swiss franc has garnered significant support from prominent investment firms, with Russell Investments and Allianz Global Investors expressing a preference for it, while JPMorgan strategists advocate for both the Swedish krona and Canadian dollar as attractive funding alternatives. These currencies are now actively competing to fill the void left by the yen, which has historically been the go-to choice for traders seeking a low-yielding currency to borrow.

The Swiss franc's appeal stems partly from the policy divergence between Switzerland and Japan, according to Van Luu, head of global fixed income and FX solutions at Russell Investments. He noted that Switzerland is expected to maintain zero interest rates until 2027 and appears comfortable allowing the franc to weaken to support its exporters, making it potentially the most attractive option from valuation, monetary policy, and exchange rate policy perspectives. However, this approach carries inherent risks, as the franc's status as a premier safe-haven asset means it often strengthens significantly during geopolitical tensions or periods of global risk aversion.

Greg Hirt, chief investment officer for multi-asset strategies at Allianz Global Investors, views the franc as a viable complement to the yen but cautioned about potential volatility around French and Italian elections next year. He emphasized that the franc serves largely as a safe-haven currency when Europe faces difficulties, and would likely strengthen notably if France encountered problems, potentially undermining carry trade returns.

Nordic and North American Currencies Offer Alternatives

JPMorgan's global FX strategy co-head Meera Chandan highlighted the Swedish krona and Canadian dollar as currencies most vulnerable to rising global rates due to their relatively lower yields and sensitivity to the economic cycle. She's recommending clients sell both currencies against the dollar, which is currently supported by market expectations of potentially two Federal Reserve rate cuts this year. Her analysis points to substantial yield differentials when comparing them against higher-yielding developed market currencies like the Australian or Norwegian, or even against higher-returning emerging market currencies. She noted that the franc and New Zealand dollar also fit her criteria for potential funding currencies.

The transition, however, is not without complications. The yen's liquidity remains vastly superior to most other currencies, and carry strategies historically work best during periods of exchange rate stability. A key relationship that once benefited yen-funded trades is also breaking down: the yen has traditionally been the currency most sensitive to U.S. interest rates, typically weakening as two-year Treasury yields rose, but this correlation has now shifted to other currencies.

This fundamental shift suggests that the global carry trade landscape is entering a new era, characterized by currency diversification and potentially reduced overall leverage. Investors choosing to maintain their underlying asset exposure may simply swap their funding currency, converting Swiss francs or Swedish kronor to repay yen obligations while keeping their foreign investments intact. In this scenario, funds would not necessarily flow out of stocks or bonds. Conversely, those opting to unwind their positions entirely would sell assets to repay yen loans, leaving any residual capital to potentially move toward cash, short-term government securities, or other investment vehicles.

Israeli data from mid-September showed Japanese investors still made net purchases of approximately 1.3 trillion yen in foreign equities during August, suggesting that overseas allocations and yen position unwinding can coexist. The International Monetary Fund has observed that while rising Japanese bond yields could influence global allocation patterns, adjustments by large institutional investors typically occur gradually, indicating any transition toward a new funding currency regime will likely be measured and incremental.

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