Japanic Attack

While many investors have been very focused on the rapid evolution of AI, one of the world’s largest economies, Japan, has been under siege. Japan’s problems have been brewing since the massive Japanese asset bubble burst back in 1989.

The latest episode in Japan began with a sudden rise in long-term yields, which has the potential to throw global bond markets into a panic. For more than 30 years, Japanese interest rates have been among the lowest of any industrialized nation. Consequently, Japanese investors have used their yen—and those outside Japan have borrowed it—to invest at higher rates in other countries, particularly the United States. This strategy has been used for so long it even has a specific name: the yen carry trade.

U.S. markets have been a primary beneficiary of this demand, which at the margin tends to put downward pressure on US interest rates and upward pressure on U.S. equity markets. However, the recent increase in Japanese rates has begun to crimp the yen carry trade, and that trend could accelerate rapidly.

The Yen Carry Trade & Market Volatility

Japan remains the largest foreign holder of U.S. Treasuries, with more than $1 trillion in holdings. It has played a vital role in funding the massive US government deficit by purchasing Treasury bonds at attractive yields compared to local Japanese rates.

While the Japanese policy rate remains low at 0.75%, long term rates in Japan have been rising as inflation has picked up and the Bank of Japan is gradually shifting away from its ultra-low rate policy. In addition, a massive stimulus package has been proposed by Prime Minister Takaichi as well as the suspension of some taxes, all creating concerns that this will worsen Japan’s already massive public debt burden. Bond buyers are now demanding higher yields to compensate them for that risk. In short, the Japanese bond vigilantes are beginning to speak up.

Although this sounds like a “Japan problem” the impact of these issues can easily expand globally and threaten stability in global markets. The actual size of the yen carry trade is unknown but typical estimates range from $1 trillion to $3 trillion. Any rapid unwind of these carry trades could cause very significant volatility in the global bond markets that would likely roll over into the global equity markets – a ‘Japanic Attack’, if you will.

“Plaza Accord II” Coming?

Today there is talk of Plaza Accord II with the U.S. and Japan in a coordinated effort to stem the weakness of the Yen relative to the dollar. (The first Plaza Accord was in 1985 and resulted in the coordinated de-valuing of the U.S. dollar relative to the Japanese yen and the German Mark.) The weakness of the Japanese yen has been driving up food and energy costs. A stronger Yen would ease this inflationary pressure in an economy that is a large net importer of food and energy. But a stronger yen would also push Japanese rates higher and that could accelerate the unwind of the yen carry trade and that is the current concern. A gradual unwind can be handled by markets, but a step-function de-valuation of the dollar vs. the yen could cause a sudden and large unwind.

It is important to note that traders may be concerned about this, but long-term investors need not respond as this will eventually even out, whether fast or slow. Long-term investors should be prepared for the possibility of some short-term volatility.

What Would it Mean for the U.S .Economy?

For the U.S., a coordinated intervention to weaken the dollar would have mixed effects:

  • Boost to exports: A weaker dollar makes U.S. goods and services cheaper for foreign buyers, which can improve the U.S. trade deficit and support American jobs and support the Trump administration’s re-shoring policy.
  • Potential inflationary pressure: On the other hand, a weaker dollar makes imports here more expensive, and can add to domestic inflationary pressure, which is a concern for U.S. monetary policymakers.
  • Market volatility and yields: If Japan is forced to sell a significant portion of its large U.S. Treasury holdings to fund the intervention, it could push up U.S. bond yields and add to existing market volatility.
  • Policy conflict: The U.S. generally maintains a “strong dollar policy” driven by fundamental economic conditions, making direct dollar-selling intervention politically complex.

 

What We’re Reading

  

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All information has been obtained from sources believed to be dependable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that no such statements are guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance is no guarantee of future returns.

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By: Adam