Disturbing Japan move has the world on edge
For 30 years there was easy money to be made in Japan. This week that all changed and it has huge repercussions for the global economy.
For decades, the more adventurous of global hedge fund managers tried their hand at what would become known as the Japanese “widow-maker” trade.
It was to short Japanese bonds on the prospect that its near-endless issuance of public debt and money printing would cause inflation and rising interest rates.
It became known as the “widow-maker” because no such inflation had ever occurred.
The flip side of the trade was the conventional wisdom that ‘Japanication’ had no end and that institutions could borrow enormous sums at zero interest rates and then invest in a high-yielding instruments elsewhere.
This is called a “carry trade”, and for 30 years, it was easy money.
The Japanese version of it grew to be so enormous that it both pioneered and substantially supported the era of global liquidity that has driven up asset prices everywhere.
As Japanese inflation becomes embedded post-Covid, these dynamics are now reversing, creating ripples of worry in financial markets.
How much debt?
Japanese public debt is around $14 trillion, so you can imagine that any meaningful move in interest rates, especially a rapid one, is going to cause economic market dyspepsia.
This is double Japan’s GDP.
Yet the concern is exaggerated. Nearly all of Japan’s debt is owed domestically, so it is denominated in yen. Japan is therefore unlikely to be vulnerable to an external crisis in which yields rise while the currency falls, driving yields even higher.
The bad news is that inflation is more embedded now than it has been for 30 years, so the Bank of Japan is pushing up interest rates to counter it.
That means there is pressure on government borrowing costs and, in turn, the carry trade.
An unwind of the Japanese carry trade is the real risk, and that means any Japanese shock may fall on asset prices elsewhere as liquidity is withdrawn from the world.
How big is the carry
A trillion here and a trillion there, and soon you’re talking serious money.
Some analyses peg the yen carry trade at an astonishing $22 trillion. This figure comes from the Bank of International Settlements and includes all derivatives.
But this is a very large exaggeration. Most of these derivatives net out as hedges for underlying securities transactions.
Japan also has $7 trillion in foreign investments, including $1.5 trillion in US treasuries. These are long-term investments and are unlikely to be affected, especially since the yen is unlikely to need support, given that any liquidation and repatriation would raise the currency.
Investment banks estimate the hot-money flow in the yen carry trade at about $1 trillion.
If this money were to go back to Japan, it might cause a currency shock to the economy on the upside, as well as deliver selling at the margin in the assets it was abandoning.
Who pays?
If the Bank of Japan were to raise the cash rate too quickly, it could trigger a combined interest rate and currency shock that damages Japanese growth.
We could also see selling in the most liquidity-dependent areas of financial markets around the world.
This would trigger or exacerbate price falls in markets such as junk debt, crypto, and non-profitable tech.
All of these assets rely on strong bids in duration, that is, the long end of the bond curve, to drive down interest rates.
As it happens, that is exactly where we are seeing pressure with bitcoin enjoying its largest-ever sell-off, junk bond markets, especially around AI hyperscalers seeing rising credit risk, and speculative areas of the equity market, like biotechs, getting hit hard.
These are likely all suffering in part due to the reversal of the yen carry trade.
How bad does it get?
Japanese core inflation is hovering around 3 per cent. The BoJ’s target is 2 per cent and its cash rate at 0.5 per cent. So further tightening is coming.
However, it is unlikely to be rushed. Japan has spent 30 years in deflation, and its natural interest rate, called r* or NAIRU, depending on where you are, is still low.
The BoJ still estimated it below zero only a year ago.
Oil prices are also very low, and liquefied natural gas (LNG) prices are set to crash due to a global glut. Japan will not see much external inflation.
In short, more ripples are coming from Japan, and liquidity-dependent assets may take more heat from that yet.
But it is unlikely to trigger a global meltdown in and of itself.
Originally published as Disturbing Japan move has the world on edge
