Transcription
For many decades, Japan was the world's financial outlier. While central banks around the world raised interest rates, Japan kept them near zero. While investors searched for cheap money, Japan provided it. And while governments, hedge funds, banks, and corporations borrowed at higher rates elsewhere, they could always turn to Japan for virtually free financing.
But right now, that era is coming to an end. Markets increasingly expect the Bank of Japan to raise interest rates again, potentially pushing them to their highest level since the mid-1990s. At first glance, of course, this may not sound like a big deal at all. After all, we're talking about interest rates moving from very low levels to somewhat less low levels. But beneath the surface lies one of the most important and least understood risks facing the global financial system today.
Because if Japanese investors begin bringing their money home, which they have already started doing by the way, I discussed it previously. And if the famous yen carry trade starts to unwind, the consequences could extend far beyond Japan. It could shake US bond markets. It could pressure stock markets around the world, too. And it could expose just how dependent the global financial system has become on cheap Japanese money. Let's break down what's happening and why investors around the world are paying attention.
Why the Bank of Japan is under pressure. For nearly three decades, Japan struggled with the opposite problem facing most Western economies today. They struggled with deflation. Prices weren't rising. Consumers delayed purchases. Economic growth stagnated. And the Bank of Japan responded by maintaining some of the lowest interest rates in modern history. At one point, Japanese interest rates were actually negative, believe it or not. In other words, investors were effectively paying the government to hold their money. This ultra loose monetary policy became a permanent feature of global finance.
But conditions have changed dramatically. Inflation in Japan has remained above the Bank of Japan's target rate for an extended period of time. Wages are now rising. Import costs remain elevated and the Japanese yen has weakened significantly against the US dollar. The weak currency has become a growing political and economic problem. Japan imports most of its energy and many key commodities. A weaker yen means that Japanese households actually pay more for fuel. They pay more for food and all imported goods. As a result of that, pressure is mounting on the Bank of Japan to normalize monetary policy.
Here's where things become interesting. The real story isn't what happens inside Japan. The real story is what happens outside Japan. Japan is one of the largest creditors in the entire world. Japanese investors collectively hold trillions of dollars in foreign assets. That includes US treasuries, European bonds, corporate debt, stocks, private equity, infrastructure projects, and virtually every major asset class that you can imagine. Why? Well, because returns in Japan were so low for so long that it was more convenient and more lucrative to invest money elsewhere. When domestic government bonds yielded close to zero, investors naturally looked elsewhere. And if you were a Japanese pension fund and US Treasury bond paid let's say four or 5% while Japanese bond paid almost nothing, the choice was very obvious. Money flowed out of Japan and into global markets. For years, this proved a massive source of liquidity for the world economy and more specifically for the US economy.
Well now, that process could begin reversing. Imagine you are a Japanese insurance company. For years, you've invested billions of dollars in US Treasury bonds because yields were much higher than what you could earn at home. But now, Japanese government bond yields are actually rising. And suddenly, you no longer need to take currency risk. You no longer need to worry about hedging costs and you can just earn attractive returns domestically. So, what do you do? Well, you sell your foreign assets and bring that money back to Japan.
This process is known as asset repatriation and if it happens on a large scale, it could create significant turbulence across global markets. Japan owns more foreign assets than any other country in the world. The country's net international investment position exceeds $4 trillion. Even a modest relocation of those assets could have major consequences. A small percentage sounds insignificant, but when you're dealing with trillions of dollars, even small percentages become very large numbers.
The United States may be particularly vulnerable. Japan has been among the largest foreign holders of US treasuries, and for decades, Japanese investors have helped finance America's deficits. But what happens if those investors start selling? Treasury yields could rise. The US government could face higher borrowing costs. Mortgage rates could increase. Corporate financing could become more expensive and financial conditions across the economy would tighten. This matters because the United States is already running enormous fiscal deficits. Washington needs constant demand for Treasury securities in order to keep up its operations. And any reduction in foreign demand actually increases pressure on domestic buyers to absorb new debt issuance. And what that does is it, it could mean higher yields across the curve. The irony here is striking. Of course, many investors focus on what the Federal Reserve is doing, but one of the biggest risks to US borrowing costs may come from decisions that are made thousands of miles away in Tokyo.
Now, let's talk about what may be the most important piece of this entire puzzle, the yen carry trade. For years, investors borrowed money in Japanese yen at extremely low interest rates. They then converted those funds into dollars or other currencies and invested in higher yielding assets. The strategy became one of the most popular trades in global finance. Hedge funds used it, banks used it, corporations used it, and asset managers did as well. The logic was very simple. Borrow cheaply in Japan, invest elsewhere, and pocket the difference. As long as the yen remained stable or weakened, the trade generated very attractive returns.
But rate hikes change everything. When Japanese interest rates rise, borrowing costs increase. And if the yen strengthens, investors face currency losses. Suddenly, a trade that looked very safe and very profitable becomes very dangerous. Investors rush to unwind positions. Assets get sold, borrowed yen gets repurchased, and market volatility increases. This is where financial history becomes important. Carry trades tend to work quietly for years, but when they unwind, they unwind violently. When everyone tries to exit at the same time, what happens? Liquidity disappears. Investors sell what they can sell and they don't really want to take a profit. They just want to get rid of those assets. They don't want to be stuck holding the bag. So stocks decline, bonds decline, credit spreads widen, emerging markets come under pressure, and volatility spreads across asset classes. So we've seen versions of this before.