Benign or Disorderly?
What happens there matters elsewhere.
One of our many oddball obsessions here at News Items is “the yen carry trade.” The yen carry trade involves borrowing in Japanese yen, which historically has had ultra-low or negative interest rates, and converting those funds into higher-yielding currencies or assets to profit from the interest rate differential. What happens, we (occasionally) wonder, if Japan’s “ultra-low” interest rates are no longer “ultra-low”?
Needless to say, we have no idea. But happily enough, we know someone who does. Her name is Rebecca Patterson. This from her CFR bio:
(Rebecca) is a senior fellow at the Council on Foreign Relations (CFR). A globally recognized investor and macro-economic researcher with more than twenty-five years of experience across the U.S., Europe, and Asia, Patterson studies how politics and policy intersect with economic trends to drive financial markets.
Previously, Patterson was chief investment strategist for Bridgewater Associates, the world’s largest hedge fund. From 2012 through 2019, Patterson was chief investment officer of Bessemer Trust, a multi-family office where she managed $85 billion in client assets. Before joining Bessemer, Patterson spent more than fifteen years at JPMorgan, where she worked as a researcher in the firm’s investment bank in Europe, Singapore, and the U.S., served as chief investment strategist in the asset management arm of the firm, and ran the Private Bank’s global currency and commodity trading desk. Patterson’s transition to finance came after several years working as a journalist, covering financial markets, policy, and politics in the U.S. and Europe.
Qualified!
Rebecca frequently writes for what U.S. Attorney General Pam Bondi might describe as “loser liberal rags” (like The New York Times and the Financial Times). We’re very pleased she chose to write this piece for News Items. It’s a really good piece.
The World Should Closely Watch Japan’s Reflationary Push.
Elections last weekend gave Japanese Prime Minister Sanae Takaichi a bright green light for new fiscal stimulus, in the form of a two-thirds supermajority in the Lower House of parliament. The rest of the world should pay attention. Global financial markets and economic spillovers seem certain. Whether they prove fairly benign or disorderly is not.
In sharp contrast to much of the last 30 years when Japan was desperately trying to ward off deflation, the likely next wave of Japanese government support will occur against a backdrop of 2%-plus inflation. The combination of continued economic growth and higher inflation will bias the Bank of Japan towards further policy tightening, raising both short- and long-term interest rates.
So far, Japanese reflation, coupled with ongoing corporate reform, has been applauded by investors worldwide. Since the start of 2023, Japan’s TOPIX equity index has gained just under 100%, outpacing the MSCI World global equity index and the U.S. S&P 500 index, up by 71% and 80% (give or take), respectively. Global equity capital has leaned into Japan, even as the country’s borrowing costs have risen (the 10-year government bond yield increased from 45 to 222 basis points over the same period).
The positive shift in growth and corporate profit sentiment has overwhelmed worries about the country’s underlying demographically-driven debt challenges, outside a few short-lived bouts of interest-rate-led volatility. The trillion-yen questions are how much further Japanese interest rates rise, how quickly, and whether higher yields are influenced more by growth hopes or fiscal fears.
The Goldilocks outcome would see yields rising only modestly as Takaichi’s government and the central bank lead an economy with controlled inflation alongside improving growth, the latter helped by stimulus-fueled productivity gains. In this scenario, the cost of higher yields for companies and households could be mitigated in part by strong Japanese equity returns. Meanwhile, if Japan can get the real interest rate that the government needs to pay on its debt below the real economic growth rate, it can stabilize the debt-to-GDP ratio.
A much more concerning scenario would echo what occurred in January this year. Heightened fiscal concerns in the face of rising interest rates dominated investor sentiment. Longer-term Japanese government bond (JGB) yields quickly rose as investors demanded greater compensation, or term premium, to loan Japan money. Global contagion followed.
Importantly, in either scenario, the amount of global capital taking advantage of low Japanese interest rates to fund purchases of higher-yielding assets elsewhere is likely to decline – potentially influencing those overseas’ asset values significantly. Whether that happens in a more or less orderly way will depend in part on which Japan “scenario” becomes reality.
Japan’s Demographic Decline Key Driver of Rising Government Debt.
Thinking through the brighter and darker Japanese economic scenarios first requires an understanding of the structural challenges that got the country to this juncture. The central issue is demographics. Decades of falling fertility rates and longer life expectancy have resulted in a shrinking population (since 2008) and labor force. That has meant less tax revenue and greater government expenses to care for the elderly.
Not surprisingly, these demographic trends have led to the second structural challenge for Japan today: persistent budget deficits since 1993 and rising government debt as a share of GDP. Japan now leads the world with a debt/GDP ratio over 230%. That Japan has been able to carry this massive government debt without triggering any sustained market reaction is the result of circumstances as much as planning. Thanks to a prolonged period of corporate and household deleveraging that pulled inflation down to effectively nothing, the Bank of Japan adopted a zero-interest rate policy (ZIRP) in 1999, followed by a negative rate policy (NIRP) and explicit control over longer-term government bond yields.
Rock-bottom borrowing costs kept a lid on Japan’s debt interest payments. Meanwhile, the government focused on issuing longer-term bonds to lock in low borrowing costs for an extended period. ZIRP, NIRP and yield-control policies, spanning well over two decades, largely kept bond vigilantes at bay. Indeed, the investors who repeatedly tried and failed to profit by shorting JGBs earned this trade the nickname “widow-maker”.
The period also fueled a separate, and much more profitable investment strategy: the so-called yen carry trade. This trade, and the potential for it to unwind, is a large part of the global contagion that could unfold if Japanese interest rates continue to march higher.
For the last few decades, both Japanese and foreign investors have taken advantage of low Japanese yields, borrowing in yen to purchase higher-yielding assets elsewhere. As long as the exchange rate and the purchased asset’s valuation remained relatively stable, the investor could “carry home” the difference in yields as a reliable part of the total return.
Estimating the size of the yen carry trade today is difficult. As my Council on Foreign Relations colleague Brad Setser showed in a detailed March 2024 research note, different types of investors have different strategies and time frames that will influence how much and how quickly they may want to shift portfolio allocations in the event of rising Japanese interest rates that make the carry trade less attractive.
Still, a quick scan across the Japanese financial landscape provides a sense of the magnitude of what could occur, even if just a small portfolio shift occurred. Japan’s massive government pension fund (GPIF), for instance, keeps a quarter of its approximately 294-trillion-yen portfolio each in foreign equities and bonds (that’s roughly $950 billion in foreign assets held by the fund). More foreign assets are held by Japanese commercial and savings banks, life insurers and retail investors, in addition to the Bank of Japan that holds more than $1.2 trillion in U.S. Treasuries alone as part of its foreign-exchange reserves. There are also non-Japanese investors to consider, who could have borrowed yen to buy higher-yielding investments elsewhere.
Further Increases in Japanese Yields Likely to Trigger Global Capital Flow Shifts
Looking ahead, new fiscal stimulus is likely to be delivered to both frustrated Japanese households struggling to manage a return of inflation, and to a government intent on strengthening its defenses and ensuring sufficient rates of longer-term growth (especially in the absence of a growing labor force). Continued, albeit gradual monetary tightening seems likely to keep related price pressures under control – that will bias yields higher and increase Japan’s interest payment burden. So too will greater JGB issuance that is required to fund the government’s largesse.
At some point, more attractive Japanese bond yields, especially if they occur alongside a healthy economy and are converging with bond yields in other developed countries, will likely lead to incremental portfolio shifts in favor of Japan.
There are two implications of this for overseas markets. First, the “peak carry trade” could be in the rearview mirror, especially if policymakers stay focused on controlling inflation and limiting yen weakness. (Recent Japanese verbal intervention and the January episode of “checking rates” in foreign-exchange markets have led many investors to expect a dollar-yen rate of 160 could prove a line in the sand that officials will try to defend.)
An unwind of carry trades would mean relatively less demand for higher-yielding assets broadly – from U.S. fixed income to emerging-market currencies. That’s a particular problem for financial markets that heavily rely on carry-trade-related support.
Even if an unwind of carry trades proves gradual, limiting global spillovers, higher JGB yields will still be felt. Over the last few decades, greater financial integration has contributed to more cross-border market contagion. A monetary change in one country can influence currency rates, bond risk premia and financial conditions in other countries, especially if the countries are financially and economically integrated (which is broadly the case today, especially across developed economies).
Research from the Bank for International Settlements examined monetary policy shocks originating from seven developed economies and their impact on 47 developed and emerging bond markets. While contagion was greater from U.S. and Euro area monetary shocks, the research still found mild spillovers emanating from other central banks, including the Bank of Japan and Bank of England. Contagion in bond markets was felt most in longer-duration paper.
In recent years, such contagion has appeared more frequently in developed economies, as investors have taken more notice of large, persistent budget deficits and increasingly concerning government debt forecasts. They have shifted portfolios, at least tactically and often until policymakers stepped in to calm investors, in response to catalysts that changed bond supply and demand expectations, including monetary policy decisions.
Three brief examples illustrate that bond markets much smaller than America’s can still have global influence.
First, in September 2022, then-U.K. Prime Minister Liz Truss proposed surprisingly large fiscal stimulus against a backdrop of already high inflation and rising interest rates. Beyond a spike in U.K. government bond yields and a record one-day drop in the value of sterling, contagion was felt across European and U.S. markets, with the 10-year U.S. Treasury yield rising 9 basis points in two days.
Another example in December the same year came from Japan, when the BoJ unexpectedly widened its allowed trading range for 10-year JGB yields (an easing of the yield control policies). The bond yield quickly rose to its highest level since 2015 and local stocks fell sharply. The U.S. 10-year Treasury yield rose sharply on the news.
More recently, on July 31, 2024, the BoJ surprised markets when it raised policy rates. JGB yields initially rose and the yen strengthened, reportedly as carry trades were quickly reduced. Contagion was felt acutely across equity, bond and currency markets, with higher yielding currencies from Mexico, Brazil and Turkey all declining.
Putting this together, both the potential for a carry unwind and the risk of contagion from Japanese fiscal fears shine a light on risks for developed economies including the U.S.,France and the U.K. in particular, given their own persistent budget deficits that require more demand to absorb greater bond issuance.
Indeed, a 2025 Journal of Economic Perspectives research paper highlights how the “fiscal challenges now faced by the United States bear striking similarities to those Japan encountered several decades ago” in terms of increasing debt loads and demographics that the paper’s authors suggest could ultimately trigger a public debt crisis.
Each of these vulnerable economies have nuances that will influence how capital flows are absorbed and get reflected in local market prices. In the U.S., for instance, Treasury Secretary Bessent has actively sought to bolster other Treasury demand sources, including dollar stablecoin reserves and banks. That could help offset a relative loss of Treasury demand from carry-trade investors in and outside Japan.
Risks could also be mitigated if Japanese stimulus proves sufficient to offset the drag from the country’s demographics and accelerate the pace of economic growth, allowing the central bank to continue normalizing policy to keep inflation in check and the yen relatively supported. More resilient global economic conditions tend to support investor sentiment, reducing the duration and severity of any bouts of market volatility.
All that said, a lot is riding on Prime Minister Takaichi and the Bank of Japan, not just for Japan’s economic prospects but for global financial markets. A Goldilocks outcome is possible but far from given, which makes understanding these risks all the more important.
I follow Rebecca Patterson and I find her perspective to be well balanced, insightful and approachable. We’ve exchanged notes and she’s quite gracious, too!