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The Bank of Japan’s signal that it could soon raise interest rates again has added fuel to a brutal sell-off in the country’s bonds this year and sent a tremor through global financial markets.
Governor Kazuo Ueda on Monday used language taken by many economists as a clear indication he is preparing markets for a move before the year is out. Swaps markets are now pricing in a two-thirds chance of a rate rise this month.
After years of negative interest rates, which only ended last year and which allowed investors to borrow cheaply to buy higher-yielding foreign assets, global markets are now bracing themselves for the fallout from higher Japanese borrowing costs.
What impact has Ueda’s speech had on markets?
After Ueda’s speech, the yield on the two-year Japanese government bond hit a 17-year high while the yield on the 10-year note, which has risen more than 0.8 percentage points this year, reached 1.94 per cent on Thursday. Yields move inversely to prices. The yen jumped as much as 0.8 per cent against the dollar on Monday and is now up by around 1 per cent this week.
Global bond markets felt the ripples, with 10-year German Bund yields climbing 0.06 percentage points and the 10-year US Treasury yield jumping 0.08 percentage points on the day.
The volatility echoes ructions earlier in the year when concerns over demand for Japan’s long-dated sovereign bonds added to broader worries about an imbalance between supply and demand for sovereign debt globally.
“The lessons from these episodes are that JGB sell-offs really matter for global bond markets,” said Mike Riddell, a fund manager at Fidelity International.
“The higher JGB yields go, the more incentivised the huge Japanese domestic investors are to sell overseas holdings and bring the money back home,” he said. “Contagion can then rapidly spread outside of Japan.”
Why is the yen carry trade important?
Japan’s long experiment with ultra-low rates and the yen’s relative stability made it the centre of one of the world’s biggest carry trades, where investors borrow in yen to fund investments in higher-yielding assets overseas.
Estimates of the size and reach of the yen carry trade vary wildly — ranging from hundreds of billions to trillions of dollars — but it is seen as helping fuel bull markets in mainstream financial markets such as stocks and bonds as well as emerging markets, property, private credit and art.
Investors using the carry trade are particularly sensitive to high levels of currency volatility and to rapidly changing expectations around interest rate moves by central banks, and will have taken note of Ueda’s comments and growing expectations of rate cuts by the US Federal Reserve.
“Japan’s certainly been a source of savings for the rest of the world. If any of those flows pare back into the local market you see this ripple effect globally,” said Michael Langham, an emerging markets economist at Aberdeen.
What could this mean for Japanese and global markets?
The BoJ’s rate rise in July 2024 was followed by the equity market’s second-worst one-day crash in history — a 12 per cent collapse that traders said was linked to the possible unwinding of yen carry trades. The Japanese currency strengthened sharply while Wall Street’s blue-chip S&P 500 index sold off.
Japanese and global stocks also fell on Monday this week, although the impact was more modest, with the Topix losing 1.2 per cent.
Japan is a big creditor to the world, surpassing China as the largest holder of US Treasuries. Some investors worry rising JGB yields could trigger a repatriation of Japanese capital and fuel volatility in US and other major bond markets.
That would come amid investor concerns globally about demand from traditional buyers such as pension funds and life insurers for long-term sovereign debt, at a time of record issuance by rich nations and after central banks have mostly dialled back their pandemic-era bond-buying programmes.
“Rising local rates are pulling capital home [to Japan],” said James Novotny, an investment manager at Jupiter. “For foreign sovereigns, one less buyer couldn’t come at a worse time.”
Some fear that such tremors in bond markets could spill over to other asset classes.
Manish Kabra, US equities strategist at Société Générale, said that “a hawkish move from the Bank of Japan is a bigger threat to the US equity market than the Federal Reserve, or US domestic policy”, because of the possible contagion to US Treasury yields.
Kabra said that a 1 percentage point rise in the 10-year Treasury yield would likely trigger a 10-to-12 per cent drop in the S&P 500, making bond market volatility — while not the bank’s base case — one of the biggest risks to his bullish outlook for the year ahead.
Is everyone worried?
Not everyone is convinced there will be such a hit to global markets. Notwithstanding Monday’s rise, the yen has weakened in recent months, while changes in relative interest rates after hedging costs are taken into account could mean foreign bonds retain their attraction.
The Japanese Government Pension Investment Fund is mandated to maintain a strict — and seldom adjusted — allocation of a quarter of its portfolio to non-Japanese bonds, and many other domestic pension funds follow the investment fund’s allocation. A mass, off-cycle allocation change is unlikely to happen overnight.
“I don’t think you’re going to have a mass sell-off because the BoJ is hiking rates,” said Vincent Chung, a fixed income portfolio manager at T Rowe Price.
Max Kettner, chief multi-asset strategist at HSBC, said the situation today is different from last year’s market wobbles.
“This year, speculative investors have gone record net long [the yen] — so therefore there’s limited risk of a significant carry trade unwinding as we’ve seen it last in summer 2024,” he said.
Additional reporting by Ian Smith, Emily Herbert and Rachel Rees in London and William Sandlund in Hong Kong
