Investors are worrying about potential spillover from surging Japanese bond yields. Here's a breakdown of what matters.

By Joseph Adinolfi

Another Bank of Japan rate hike later this month is widely expected. That's one reason it isn't likely trigger a repeat of the brutal 2024 yen-carry unwind.

Investors shouldn't worry about another yen carry trade unwind, Wall Street professionals say.

Rising Japanese bond yields, coupled with the expectation that the Bank of Japan will raise interest rates again later this month for the first time since January, has breathed new life into a Wall Street boogeyman.

It has been discussed on podcasts, and in breathless social-media posts like the one below: The idea that rising Japanese yields could trigger another painful unwind of the so-called yen carry trade, similar to what investors experienced on Aug. 5, 2024. Or even more painful: A tidal wave of selling by Japanese investors seeking to bring their money back home.

While the exact size of the Japanese yen carry trade can be difficult to gauge, several Wall Street strategists and portfolio managers told MarketWatch that the macroeconomic footprint of the trade has shrunk dramatically, according to several indicators they monitor.

The yen carry trade flourished in an era where the Bank of Japan kept a tight lid on interest rates and government bond yields, policies it only recently tried to "normalize." A carry trade involves borrowing in one currency with a relatively low interest rate, then swapping the borrowed money into another currency with a relatively higher interest rate.

That was a steady and stable "haven" bet for many investors until recent years, when the BoJ has looked to loosen its control over over Japanese financial markets.

In a recent edition of his Substack newsletter, Bob Elliott, chief investment officer at investment firm Unlimited and former executive at hedge fund Bridgewater Associates, dismissed concerns about another carry-trade blowup as "clickbait fears." He later told MarketWatch that, in his view, the influence of the yen carry trade on global markets has shrunk dramatically since the global financial crisis.

On Aug. 5, 2024, the Japanese yen (USDJPY) surged by nearly 3% against the U.S. dollar, triggering a global stock-market rout that saw Japan's Nikkei 225 JP:NIK fall by more than 12%, its biggest drop since the 1987 "Black Monday" meltdown, according to Dow Jones Market Data. The unwind of the yen carry trade was widely blamed for sparking this selloff, but Elliott disagrees. In reality, the yen's rally on that day was likely driven by other market dynamics, he told MarketWatch.

Rising JGB yields make investors uneasy

Earlier this month, the Japanese legislature approved an economic stimulus package valued at approximately -Yen21.3 trillion. The spending, a critical pillar of new Prime Minister Sanae Takaichi's economic agenda, comes as the Bank of Japan has been easing its grip on the country's bond market.

The spending package left Japanese bondholders unnerved. Japan already has among the highest ratios of sovereign debt of any developed nation, at more than twice the size of the country's annual GDP, IMF data showed. By comparison, the U.S. debt burden stands at roughly 120% of GDP.

Since the late 1990s, the BoJ has largely kept interest rates at rock-bottom levels. During the 2010s, it even moved a policy rate into negative territory in an effort to stimulate demand in an economy that for years struggled with deflation. That created an opportunity for investors from around the world to borrow cheaply in Japanese yen, and use the money to fund investments in other markets.

But more recently, it has shifted to a policy of slowly raising interest rates as inflationary pressures have finally returned. Yields on Japanese bonds rose to fresh multidecade highs on Thursday, with the yield on the 10-year Japanese government bond BX:TMBMKJP-10Y hitting 1.937%, its highest level in 18 years, LSEG data showed. Yields on longer-dated bonds have also hit their highest levels in decades.

As local yields have risen, the country's yield curve, which measures the difference in yields between short-dated and long-dated debt, has steepened dramatically, FactSet data showed. The changing slope can be seen in the chart below. Steeper yield curves can result in elevated longer-term borrowing costs for households, companies and governments.

When it comes to monitoring the size of the carry trade, Adarsh Sinha, head of G-10 currency strategy, said during a BofA Global Research media roundtable on Thursday that he looks at a few different indicators. These include: Yen-denominated bond issuance by foreign companies, positioning data for dollar-yen currency futures published weekly by the CFTC, and positioning of Japanese retail investors. Currency trading by small-time investors in Japan is more popular than it is in the U.S., experts said.

Many investment firms also use over-the-counter derivatives like currency swaps and forwards to hedge their currency risk, or speculate. That makes the true size of the carry trade very difficult to measure effectively.

"When you look at the data, there's no sign right now of an excessive yen carry trade buildup," Sinha said during the roundtable discussion.

Although weekly CFTC positioning reports have been delayed by the U.S. government shutdown, the most recent data showed overall positioning at close to neutral, as the below chart shows. Ahead of the August 2024 blowup, speculators were extremely short on the yen.

Another sign that a carry trade unwind is no longer a threat: The relationship between the yen and U.S. stock indexes like the Nasdaq Composite COMP and S&P 500 SPX has started to shift. This is partly due to the fact that as Japanese bond yields have moved higher this year, the Japanese currency has weakened, sapping some of the yen's appeal as a safe haven, said Peter Vassallo, a portfolio manager at BNP Paribas Asset Management who focuses on currencies. As a result, a sudden surge in the value of the yen, and a global stock-market selloff, wouldn't necessarily co-occur.

"I just don't see any evidence for a big position overhang in the yen," Vassallo told MarketWatch.

Bank of Japan Governor Kazuo Ueda earlier this week caused a stir in global bond markets when he suggested the central bank could raise interest rates at its meeting later this month. His comments helped revive fears of a carry trade unwind, with some pointing to a concomitant drop in bitcoin prices as a sign that rising Japanese bond yields were causing liquidity issues in global markets.

But as Vassallo pointed out, overnight interest-rate swaps in Japan are already pricing in a roughly 80% chance that the central bank will deliver another 25-basis-point rate hike at its upcoming meeting, which is set to conclude on Dec. 19.

That means investors have had ample opportunity to prepare for the hike, removing the element of surprise that helped trigger the 2024 carry trade rout.

As for the idea that, past a certain point, Japanese government bond yields could trigger a global stock-market meltdown, that is also pretty far-fetched, said Dhaval Joshi of BCA Research.

Large Japanese investors like the country's Government Pension Investment Fund typically set out their asset-allocation plans years in advance. Any decision to unwind holdings in foreign assets would likely happen gradually over a period of years.

"There isn't a critical level [for Japanese bond yields] that is going to cause a tsunami of capital flooding back to Japan. That's not going to happen," Joshi said.

In short, while rising Japanese bond yields could certainly crimp global liquidity, any fallout for global markets would probably be modest, Joshi added.

-Joseph Adinolfi

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