Transcription
Welcome back everyone. Thank you so much for being here. Thank you for taking the time and uh a special thank you to those who have become new subscribers on my Patreon or Substack. As for my previous announcement, it was absolutely wonderful to see so many of you join those two platforms. It was great to see you there and I really appreciate you staying uh connected and also making sure that you have a way to stay connected in case there is a purge on YouTube.
Now, let's get to the topic of today's video. For decades, Japan was seen as the world's quiet financial giant, and that is not an understatement. Its economy grew slowly. Inflation barely existed, and interest rates stayed close to zero for years. But underneath that calm surface, Japan became one of the most important pillars supporting the global financial system. And right now that pillar may be starting to shift and to crack in a way that will send shock waves through the United States and the global economy.
Most people think that the biggest foreign influence on US markets actually comes from China, but in reality, Japan may be even more important. Japan holds roughly $1.2 2 trillion dollar in US Treasury bonds, which makes it America's largest foreign creditor. At the same time, Japan has an enormous domestic bond market that is worth around $8 trillion, which is the third largest bond market in the world.
For years, Japanese investors and institutions helped supply cheap liquidity to global markets by investing heavily in foreign assets, especially in American government bonds and equities and stocks. So that system worked well because Japan kept interest rates extraordinarily low for many, many years. In fact, for decades, the Bank of Japan effectively flooded the financial system with cheap money in an attempt to fight deflation and to stimulate growth. Japanese investors could borrow at near zero rates and they could invest in higher yielding assets overseas, which is precisely what they did. And so that became known as the yen carry trade and it turned Japan into one of the biggest sources of liquidity for global markets.
But now that era may be ending. In fact, it is ending if we were being realistic. Back in 2024, and this is important to provide context, but back in 2024, the Bank of Japan officially abandoned one of the most extreme monetary policies in modern history. its yield curve control policy. For years, the BOJ artificially suppressed Japanese government bond yields, keeping long-term rates near zero. But inflation in Japan finally began rising toward the central bank's 2% target rate. And so faced with mounting inflationary pressure, the Bank of Japan started allowing interest rates to rise. The consequences were immediate. Japanese government bond yields surged higher. 10-year Japanese bond yields roughly doubled to over 2% while 20-year yields climbed above 3.5%. Those numbers may still look quite low compared to some western countries, but for Japan, this was a seismic change. Japan had spent decades that effectively been trapped in a world of ultra low rates. And now investors were suddenly facing a completely different reality.
Now at the same time, Japan's political leadership also shifted in a more aggressive direction. Prime Minister Senetakichi came to power promising largecale economic stimulus and uh she delivered. She pledged roughly 134 billion in new spending which is an equivalent to about 3% of Japan's GDP. She also proposed suspending an 8% uh food import tax for two years in an effort to reduce food prices and to ease pressure on households that are struggling with inflation.
But the stimulus push is actually happening at an extremely dangerous moment for Japan's finances. Japan already has the highest debt burden in the developed world, higher even than the United States with public debt sitting around 230% of Japan's GDP. This is far higher than the debt levels of the United States um or European countries as I mentioned. And unlike faster growing economies, Japan faces serious demographic problems. its population is shrinking and aging rapidly, making long-term economic growth much harder to achieve.
So that creates a potentially explosive situation. On one side, inflation is rising and then on the other side, the government wants um it wants to spend even more money while pressuring the central bank to remain accommodative. So, Takayichi has even nominated two monetary policy doves to the Bank of Japan's board, which signals that she wants losser monetary policy to support her economic agenda. At the same time, the Japanese yen has already weakened dramatically against the US dollar um and it fell to levels not seen in decades. A weak currency makes imports more expensive, especially energy and food, which can push inflation even higher. Investors are beginning to wonder whether Japan can continue managing its massive debt burden if borrowing costs keep rising.
And so this is where the story becomes extremely important for the United States. If Japanese bond yields continue rising, Japanese investors may begin pulling money out of US financial markets and bringing it back home. For years, US Treasury bonds looked attractive compared to near zero Japanese yields. But if Japanese government bonds now offer competitive returns combined with the possibility of uh strengthening yen, many Japanese investors could decide that there is less reason to hold American assets. And so that process is known as capital repatriation and it could have enormous consequences for US markets.
The timing could hardly be worse for Washington. The US government already needs uh to finance enormous deficits because the US government has been operating at a deficit for decades. America must issue trillions of dollars in new debt while also refinancing massive amounts of existing Treasury bonds that are coming due. If one of the world's biggest foreign buyers starts stepping back from this market, borrowing costs in the United States could rise even further. And it's not just the Treasury market at risk, by the way. The unwinding of the Japanese carry trade could drain liquidity from global financial markets more broadly. For over a decade, cheap Japanese money helped fuel investment in stocks, in real estate, and in risk assets around the entire world. If that flow reverses, which it is about to reverse, financial conditions could tighten rapidly.
Some analysts are now drawing uncomfortable comparisons to periods that preceded past financial crisis. For example, associate head general strategist Albert Edwards recently warned that the sharp rise in global bond yields resembles conditions seen before the 2008 financial crisis. I just recorded an entire interview with the economist Michael Hudson who spelled it out for us in great detail and I highly highly recommend that you watch that interview next. And he pointed out that 30-year US Treasury yields recently climbed above 5.2% which are the levels that were last seen in mid 2007 just before the housing crisis spiraled into a global meltdown. Now, back then, markets initially ignored the warning signs. Of course, stocks continued climbing for a while, even as bond yields surged higher. But eventually, rising borrowing costs began damaging the economy. Corporate profits weakened, recession fears spread, and financial markets collapsed. That was 2008. Well, Professor Hudson believes that something similar could happen again today. and he argues that uh you know surging bond yields will spell the demise of the global economy.
As Japan has become one of the central pressure points in the global financial system, the cracks are starting to get wider and wider. And as the Bank of Japan slowly exits ultral monetary policy, Japanese bond yields are rising rapidly. So that shift is helping push global yields higher and uh tightening financial conditions um across the markets actually make the situation even worse. Long-term interest rates matter enormously because they influence nearly every corner of the economy and not just the US economy but the global economy as well. Higher bond yields increase mortgage rates, increase borrowing costs for corporations, increase government financing expenses, and um they also pressure stock market valuations. Much of the massive asset boom of the past decade was actually built on the assumption that money would remain cheap indefinitely. And if that era is ending now, investors may need to completely rethink how assets are priced.
Adding to the pressure are growing inflation concerns that are linked to geopolitical tensions, particularly rising energy prices connected to the instability in the Middle East and the United States war of aggression against Iran. Persistent inflation creates a nightmare scenario for central banks because it limits their ability to cut interest rates even if economic growth slows. So that combination and again I'm talking about rising yields, slowing growth, stubborn inflation, massive government debt. The combination is exactly what worries many market strategies today.
There are essentially two possible path forward for Japan. In the best case scenario, Japan moves carefully. The government scales back some of its stimulus plans while the Bank of Japan continues gradually normalizing interest rates. Under this outcome, the yen could still strengthen and inflation could stabilize and Japan might avoid a full-blown debt crisis. But even this good scenario could still hurt US markets because Japanese investors may continue bringing money home may continue repatriating their funds back to Japan which reduces demand for American bonds and may potentially push US borrowing costs higher.
Now there's also a bad scenario that I want to share with you. In the worst case scenario, Japan aggressively pursues stimulus while pressuring the Bank of Japan to keep rates artificially low. Now, is Senate Takichi going to do that? We don't know. Investors of course could lose confidence in Japan's debt sustainability and it could trigger a bond market crisis and of course in turn that will result in a sharp currency decline. Such a crisis might temporarily slow capital repatriation into Japan, but it could also expose broader concerns about unsustainable government debt across the developed world, including in the United States. And that may be the deeper message that is emerging from today's bond market turmoil.
For more than a decade, global markets operated in this environment of ultra cheap money. Central banks kept rates near zero. Governments accumulated enormous debt and investors grew accustomed to endless liquidity that supports asset prices. But now inflation is returning. Bond yields are rising. In fact, they're surging. And the cost of debt is becoming impossible to ignore. Japan may simply be the first major domino showing what happens when that old system begins to crack. For investors and policy makers alike, ignoring Japan right now could be a very, very costly mistake.
I will write more about this over my substre. I know all of you are very interested in this topic and so I will develop it and discuss it in further detail as time goes by and as we hear more about the Bank of Japan's next steps. Like, subscribe, and share if you appreciate this content, if you're interested in it. And I will see you tomorrow in my new one.