Japan’s bond market, already on edge, faces a double whammy as increasing yields and possible capital flight from Japanese investment in U.S. Analysts have been particularly keen on pointing out the risks connected to the unwinding of carry trades, estimating that it might bring about serious turbulence. Japan is still the biggest holder of U.S. Treasuries in dollar terms. This, together with a deep strategic partnership with the United States, creates unprecedented prospects for both countries.
In fact, Japan now owns approximately $7.2 trillion in U.S. Treasuries. Moreover, it contains $18.5 trillion in U.S. equities, making it the world’s second largest U.S. creditor. Japan’s net external assets in 2024 hit an all-time high of 533.05 trillion yen (around $3.7 trillion). The structural relationship between Japan and U.S. financial markets is indeed deeply embedded in the broader U.S.-Japan strategic alliance. This problematic alliance has historically driven and defined investment patterns.
In recent weeks, we’ve seen Japan’s 40-year government bond yields leap to a record high of 3.689%. They were most recently traded at a spread of only 3.318%. That’s an increase of almost 70 bps since the start of the year. Japan’s 30-year government debt yields have shot up by over 60 bps, recently closing at 2.914%. At the same time, yields on 20-year government bonds have soared, rising more than 50 basis points.
Japanese life insurance companies, in particular, have increased demand for long-term bonds. Their heightened action has further inverted Japan’s yield curve after satisfying their regulatory purchase mandates. This scenario has increasingly raised alarm over capital flight. Japanese investors may choose to take their money out of the U.S. if yields continue to rise.
Albert Edwards, a global strategist at Societe Generale Corporate & Investment Banking, warns of dire consequences if Japan’s government bond yields keep climbing. He states, “If sharply higher JGB yields entice Japanese investors to return home, the unwinding of the carry trade could cause a loud sucking sound in U.S. financial assets.”
Alicia García-Herrero, the chief economist for Asia Pacific at Natixis, is quite concerned. She cautions that the unwinding of carry trades could affect the market even more severely than previous bouts of dislocation. She notes that, “The carry trade unwinding that is about to ensue will be worse than that in August.”
The recent spike in the yen, over 8% since the start of the year, has only added to this toxic mix. Analysts consider this dynamic unsustainable for Japan’s overall economy. They claim international capital is coming home and investors are paring back their dollar exposure.
Masahiko Loo, a senior analyst with one of Japan’s big four financial institutions, considers that foreign capital would rush for safety from risky assets in the event of a deep U.S. recession or a major market meltdown. He believes that Treasuries will not be the first assets affected. He states, > “While we cannot rule out some degree of foreign capital outflows from risky assets in the event of a severe US recession or an intensified ‘sell America’ narrative, we think it likely the outflow will come from equities first with corporate bonds next.”
“As such, we see little risk of divestment or ‘dumping’ of foreign bonds by Japanese investors.”
With the second quarter of 2024 upon us, analysts have pointed out the substantial divergence between U.S. and Japanese yields. Further, the spread between the U.S. 2-year Treasury yield and its Japanese counterpart is at 320 basis points. This widening gap could act as a tipping point for Japanese investors to start reallocating capital back to their home markets.
Michael Gayed, another prominent analyst, calls what’s happening in Japan a “ticking time bomb.” He cautions that loss of confidence in traditionally safe assets, like Japanese government bonds, might set off that chain reaction. This would be a major game changer for global markets. In one jaw dropping assertion he says, “Japan is a most dangerous, a ticking time bomb. Confidence in one of the financial market’s historically rock solid safe havens has evaporated. Should this trend continue, the global market would be worse off as well.
Japanese investors might hit a “full stop” and abruptly move their money back to Japan. For this reason alone, this prospect is extremely dangerous to market stability. Currency strategist Guy Stear noted that traders tend to build big carry positions when there are deep, persistent foreign exchange trends. This typically occurs when markets are calm and short-term interest rate differentials are large.
Riccardo Rebonato offers a different perspective on the situation, suggesting that rather than an immediate implosion, there may be a gradual erosion over time. He observes, “Rather than an implosion, I see a progressive erosion over a long period of time.”
Japan faces very important and difficult political, economic, and social dynamics in its bond market and international investments. What that means for U.S. and international financial markets if anything is yet unclear. Rising US Treasury yields, possible repatriation of capital and a changing mood among global investors are posing new challenges. These problems might reverberate through banking systems globally.