NextFin News - The Japanese yen is losing its crown as the world's cheapest funding currency, and strategists at BBVA see the Chinese yuan stepping into the role. The call rests on a widening policy divergence: the Bank of Japan is lifting rates toward normal territory while the People's Bank of China keeps borrowing costs at record lows, leaving yuan funding cheaper on a risk-adjusted basis even as the yen's one-way stability - the real subsidy behind the decades-old carry trade - fades.
The Setup: Two Central Banks, Opposite Directions
For roughly 15 years the mechanics of the global carry trade were almost mechanical. Borrow in yen at near-zero rates, convert into dollars, and park the proceeds in U.S. Treasuries or technology equities. The trade worked because the yen rarely did the one thing that kills a carry: appreciate sharply. That stability was itself a policy product - the Bank of Japan's yield-curve control and negative-rate regime made the currency a perpetual discount-funding source.
That era is closing. Japan's policy rate now sits at 1.00%, up from zero, and the benchmark 10-year government bond yield reached 3.02% on September 2, 2026 - up 1.38 percentage points in a year and the highest territory since the mid-1990s. The 10-year yield began 2026 just under 2.1%, pushed through 2.8% in mid-May for the first time since 1996, and touched 2.945% in mid-August. Every basis point of that rise tightens the math on a trade that only works when funding is both cheap and stable.
China is moving the other way. The People's Bank of China held its one-year loan prime rate at a record-low 3.00% in August for a 15th straight month, with the five-year rate at 3.50% and the seven-day reverse repo rate at 1.40%. Inflation ran at just 0.5% in July - deflationary territory by any central bank's standard - which means Beijing has room to keep policy easy while Tokyo tightens into 1.9% inflation. The yield spread between the two economies' 10-year bonds has widened from near zero at the start of 2026 to about 1.3 percentage points now, as Japanese rates normalized and Chinese yields stayed anchored.
The exchange rate tells the same story in a different language. The yuan has strengthened 5.85% against the dollar over the past 12 months, with USD/CNY at 6.7177 on September 3. The yen, by contrast, trades near 158 to the dollar after peaking above 163 in late July. The CNY/JPY cross sits at 23.49, up nearly 13% year on year.
Why the Yen's Real Advantage Was Never the Interest Rate
The crude comparison - Japan's 1.00% policy rate versus China's 3.00% one-year LPR - makes the BBVA call look wrong at first glance. It is not. A carry trade's profit is not the raw interest differential; it is the differential minus the currency move and minus the cost of hedging that move. The yen's dominance came from the middle term: for years, the currency simply did not move against the dollar in a way that erased the carry.
That implicit subsidy has expired. The Bank of Japan is now a tightening central bank with an inflation target it is finally meeting, and every rate-hike expectation is priced into the currency with increasing speed. The August 2024 flash crash - when a July rate hike collided with a soft U.S. jobs report and the yen surged - demonstrated the convexity risk embedded in the trade. The Bank for International Settlements recorded that the Japanese TOPIX index lost 12% in a single day on August 5, 2024, while the VIX briefly registered levels not seen since the start of the pandemic. Losses arrived suddenly and simultaneously across every position funded in yen.
Morgan Stanley estimates roughly $500 billion of yen carry positions remain outstanding. The risk is not that all of it exits tomorrow. It is that the "free optionality" - borrow cheaply and assume the funding currency stays flat - is gone. Once hedging becomes necessary, the yen's rate advantage narrows toward irrelevance.
Even the intervention that was supposed to discipline the trade backfired. After authorities stepped in to support the yen, Japanese investors bought more than 5 trillion yen of overseas assets, a flow that Monex Group's Jesper Koll said "turbo charged" carry trades rather than ending them. The incentive to borrow cheap yen had survived the jawboning - but not, BBVA argues, the rate cycle now under way.
The Yuan's Window: Low Rates, a Managed Currency, and Cheaper Hedges
The yuan offers the opposite profile. Rates are low by historical Chinese standards, the currency is managed within a daily band set by the central bank, and - critically - Beijing has shown it is more worried about the yuan strengthening too much than weakening. In February the PBOC cut the reserve requirement ratio on foreign-exchange forward sales from 20% to zero, explicitly to slow yuan appreciation. A funding currency whose issuer leans against strength is a funding currency that protects the carry.
Hedging costs have also fallen. Using the three-year cross-currency swap as a reference, implied hedging costs declined from about 3.5% in 2025 to roughly 2.3%, narrowing the penalty for converting yuan proceeds back into dollars. That matters because the yuan carry trade's historical constraint was never the onshore rate - it was the cost and availability of offshore hedging in the CNH market.
The offshore market is where the yuan's structural limitation lives. The currency has a dual structure: CNY trades onshore within mainland China under capital controls, while CNH trades offshore in markets such as Hong Kong. The two can diverge in pricing and liquidity, and offshore hedging carries wider bid-ask spreads and less favorable carry than onshore instruments. Access to onshore interest-rate swaps and cross-currency swaps is limited to designated market makers, and FX transactions face daily conversion limits and pre-trade disclosure requirements. This is the price of a currency that is internationalizing faster than it is liberalizing.
Even so, the plumbing to support larger yuan funding is being built in parallel. Panda bond issuance by foreign entities in China surpassed RMB 160 billion in the first half of 2026, a record. In June the PBOC announced an RMB repo facility for foreign and international monetary authorities at the Lujiazui Forum in Shanghai, giving official institutions a standing source of yuan liquidity. The Cross-Border Interbank Payment System is expanding, reducing dependence on dollar clearing. None of this makes the yuan freely convertible overnight. It does make yuan funding feasible at a scale that was not possible five years ago.
The Catch: Convertibility Is Not a Detail
The strongest argument against the BBVA call is also the simplest: the yuan is not the yen. Japan's capital account is fully open; China's is not. A fund that borrows CNH offshore faces thinner liquidity, wider bid-ask spreads, and the ever-present risk that access rules change. The onshore rate - 3.00% - still exceeds Japan's 1.00% policy rate, so the yuan cannot win on price alone. It wins only on a risk-adjusted basis, and only for investors who can operate inside China's regulatory perimeter.
Market participants have said as much. An explainer on the yuan carry trade noted that yuan-funded positions remain smaller than yen-funded global trades, and traders described the yuan version as unlikely to unravel quickly precisely because it has never been crowded. That is a backhanded compliment: the yuan carry is niche because it is constrained.
There is also a flow-of-funds reason to be skeptical of a rapid shift. Japan remains the largest foreign holder of U.S. Treasuries, and its investors have been selling low-yielding yen against higher-yielding G10 currencies even after the intervention, according to Masahiko Loo, a fixed income strategist at State Street Global Advisors. Carry positions are being maintained, not abandoned - which is exactly what you would expect when the funding currency's problems are well known but its alternatives are imperfect.
Second-Order Effects: Who Benefits When Funding Diversifies
If funding migrates even partially from yen to yuan, the transmission runs through three channels. First, the yen's role as the marginal funding currency for risk assets weakens, which reduces the correlation between Tokyo's policy calendar and global equity drawdowns - a modest stabilizer for U.S. technology names that were the classic carry-trade long leg. Second, Chinese borrowers and the state sector gain a larger pool of offshore yuan liquidity, reinforcing the currency's use in trade settlement and reserve holdings. Third, the dollar loses a small slice of its monopoly as the only deep, convertible funding source for emerging-market carry - a slow trend, but one that compounds.
The exposed side is equally clear. Japanese banks, which have benefited from rising rates on their domestic book, face a funding base that is no longer the world's default cheap source. And any asset class whose rally was financed by yen leverage - crypto, leveraged loans, long-duration growth equities - loses a marginal buyer as the funding advantage erodes. Japanese equities, by contrast, have enjoyed a tailwind: consensus expects earnings growth of roughly 15% this year, with banks benefiting from rising rates and industrial and technology segments riding the global AI investment boom.
There is also a subtler second-order channel through global liquidity. For years, the yen carry trade acted as a silent source of dollar liquidity: borrow yen, sell it for dollars, and those dollars end up funding risk assets worldwide. As that mechanism weakens, one source of cheap global leverage thins out - a headwind for the most rate-sensitive corners of the market even as it reduces the odds of a violent, yen-driven unwind.
What to Watch
The BBVA thesis is a cyclical call dressed in structural clothing, and it should be tested as one. The policy divergence that powers it is mean-reverting: if the Bank of Japan hikes faster than expected while China's stimulus finally lifts inflation, the spread that makes yuan funding attractive closes. The falsifying signal is specific: if USD/CNH holds above 6.90 for a sustained period - a move of roughly 2.5% from current levels - or if China's one-year LPR rises above 3.25% while the 10-year JGB yield falls below 2.5%, the risk-adjusted yuan advantage is gone.
Outlook: A Marginal Shift, Not a Regime Change
Base case: over the next 12 to 18 months, a measurable but partial rotation of new carry funding into yuan, concentrated in Asia-based investors and trade-linked corporates who already operate in CNH. The yen remains the larger funding currency by stock, but loses marginal flow. The CNY/JPY cross stays elevated, and the 10-year Japan-China yield gap holds near current levels.
Upside case for the yuan: a sharper-than-expected Fed easing cycle combined with continued BOJ tightening pushes the dollar below 150 against the yen, forcing a broader search for stable, low-cost funding. Yuan's share of global trade finance and offshore bond issuance accelerates past current trajectory, and the offshore CNH market deepens enough to absorb larger hedging flows without a widening cost penalty.
Downside case: China's stimulus rekindles inflation or capital-outflow pressures force Beijing to defend a weaker yuan, reversing the appreciation trend that makes yuan funding attractive. The carry trade stays in yen because the yen, despite its problems, remains the only deep, freely convertible low-rate currency. In that world, BBVA's call proves to be directionally right but early - the destination is correct, the timing is not.
"Going long on tech and short on the yen were two very popular trades, because for many years, the yen had been the cheapest major funding currency and tech was consistently profitable."
Michelle Gibley, director of international equity research and strategy at the Schwab Center for Financial Research, added that speculators are now positioned very long the yen and that spikes in longer-term JGB yields reflect low liquidity and the central bank's quantitative tightening as much as rate expectations. The second half of her first point is the warning: the trade was popular because it worked, not because it was inevitable.
The Bottom Line
The yuan will not dethrone the yen as the world's funding currency overnight - capital controls and convertibility rule that out. But the era of a single default funding currency is ending, and the margin of safety that made the yen carry a one-way bet has evaporated. For the next phase of the global carry trade, the winning funding currency will be whichever central bank is willing to keep its money cheap while everyone else tightens. Right now, that is Beijing, not Tokyo.
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