Developments in Japan pose risks for US
I apologize a head of time for this one, it’s going to be a bit wonky. The topic, however, is very important and extremely timely right now, so we are going to take a shot at it.
The Japanese economy has been an enigma among modern economies for decades. After an extreme boom and bust cycle in the late '90s, Japan’s economy has limped forward, not really growing but also not shrinking, as the nation changed demographically. The Japanese people and culture are remarkably productive and innovative, and their society has managed to settle into a type of comfortable stagnation.
One of the results of these decades of stagnation combined with, and partially driven by, an aging and shrinking domestic population has been an absolute tsunami of Japanese government debt. Economists and investors typically begin to fret when a nation’s government debt approaches a ratio of debt to economic output (GDP) of 100% (like the U.S.), but somehow our Japanese friends have managed to persist through a debt-to-GDP ratio well above 200% for decades. A true paradox.
Perhaps the primary tool employed to manage this massive debt is the Bank of Japan, their version of our Federal Reserve, having held interest rates at near zero percent for decades. This has allowed the Japanese government to continue borrowing to fund pensions and healthcare as the population aged. In addition, the Bank of Japan has engaged in a long program of absorbing much of the bonds being sold by the government by expanding the money supply to buy the bonds funding the government, essentially printing Yen to lend to the government at zero interest.
In most modern economies maneuvers of this type would result in persistent and difficult to manage currency weakness and domestic inflation, but due to demographic and technology trends, the Japanese managed to avoid inflation, and have actually struggled more with deflation, over decades. This trend, however, recently began to change as inflation has crept into the Japanese economy, and the implications could end up having global impacts, particularly in the U.S.
When a trend like zero percent interest rates with no inflation persists long enough, investors and speculators will inevitably develop ways to trade it for profit. In the case of Japan, this trade is known as the Yen carry trade, and it is possibly the most widely employed leveraged currency and bond trade in the world.
The trade works like this. Investors, typically sophisticated hedge funds, borrow Yen from Japanese banks at very low, almost zero percent, interest rates. They then take these borrowed Yen, exchange them for other currencies like the U.S. dollar or the Euro, and then use the converted currency to buy bonds with higher interest rates in other economies.
Perhaps the most common trade of this type involves borrowing Yen at near zero percent, exchange them for U.S. dollars and then buying U.S. Treasury bonds paying 3% to 4% to pocket the “spread” between the two rates as profit. Of course, these hedge funds tend to be dissatisfied with just collecting a 3% spread, so often these “clever” traders use their secure U.S. Treasury bonds as additional collateral to borrow more money, which is used to buy even more bonds or even other riskier assets, building super-leveraged, multi-layered trading strategies all predicated on the assumption that Yen could continue to be borrowed at near 0%. What could go wrong?
Well, a lot, and over the years a couple of hiccups have occurred with the Yen carry trade, most recently in 2024 but also in 2008 and 1998. Each prior episode boiled over to contribute to a period of enhanced volatility in global financial markets, before being contained through aggressive government policy responses. Now, as a result of a perfect storm of ongoing geopolitical and macro-economic trends, the next round of Yen carry trade stress is emerging, and this one has the capacity to end up being the “big one.” I will attempt to summarize.
It appears the money printing chickens may have come home to roost in Japan. Decades of the Bank of Japan expanding the money supply to buy government bonds, combined with energy price stress resulting from the conflict in Iran (Japan imports ALL its oil) has resulting in a cycle of currency weakness and increasing prices in a nation not used to either.
To defend the value of the Yen, the Bank of Japan has increased interest rates to the highest level since the late 1990s, and in the process, decimated the core assumption of the Yen carry trade. With the foundation of the Yen carry trade gone, traders have been selling assets to unwind their leveraged positions, including U.S. Treasury bonds, driving interest rates higher in the United States as well, resulting in the yield on the 30 Year Treasuries above 5% for the first time in decades, at a time when our own debt is reaching troublesome levels and the U.S. cannot afford higher rates. What could go wrong indeed?
While this calamity may not be dominating headlines just yet, there is a good likelihood it soon will. With U.S. investors enjoying recent all-time highs in stocks, perhaps now is a good time to take a step back and do an overall portfolio risk assessment. Hold on, this could get interesting.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
