Because Japan is the largest foreign holder of US debt, instability in its domestic bond market has a direct impact on American consumers. If Japanese bond yields rise, Japanese investors will sell their US treasuries, causing US interest rates to spike and increasing borrowing costs for mortgages and auto loans.
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Unlike the past, where economics dictated a strong yen despite loose policy, markets are now driven by politics. The Japanese government is allowing the yen to devalue to manage its debt, even as interest rates rise. This weakens the yen, strengthens the dollar, and could fuel a US equity boom via carry trades.
A popular investment strategy involves borrowing cheap Japanese Yen to buy higher-yielding US assets. This creates a hidden vulnerability. A sudden strengthening of the Yen would force these investors into a mass, simultaneous fire-sale of their US assets to cover their loans, triggering a systemic liquidity crisis.
Promises of foreign investment to build factories in the US are not funded by new money. Foreign entities sell their large holdings of US Treasury bonds to raise the cash for the real investment, creating upward pressure on interest rates.
The upcoming Bank of Japan meeting is the most critical central bank event, with implications beyond FX markets. A hawkish surprise could create a volatility event in Japan's long-end yield curve, which could easily reverberate across global rates markets, impacting carry trades and broader market stability.
The Japanese Yen's persistent weakness is driven by the Bank of Japan's implicit choice to prioritize domestic financial stability, specifically in the government bond market, over the currency's value. This means that despite threats, FX intervention is a secondary tool, and the BOJ will allow the yen to "free float relatively more" to avoid bond market disruption.
Investors borrow Japanese Yen at low interest rates to buy high-growth assets like NVIDIA, pocketing the difference. When Japanese rates rise, these investors must sell their stocks to cover the debt, causing a cascade of selling pressure unrelated to the company's performance, revealing global market interconnectedness.
As the first major economy to reach its debt limit, Japan's bond market is seizing up, forcing capital into riskier assets like equities. This dynamic of a bursting sovereign bond bubble inadvertently fueling the real economy is a likely preview of the path the United States will eventually follow.
A critical but overlooked risk for the U.S. credit market is rising interest rates in Japan. Japanese banks are major buyers of AAA-rated Collateralized Loan Obligations (CLOs). If domestic yields become more attractive, they may pull back, removing a significant source of demand that underpins the entire leveraged loan ecosystem.
The recent flattening of Japan's yield curve masks underlying structural weakness in the superlong-end bond market. Reduced purchases by the Bank of Japan will keep net supply high, creating a challenging supply-demand dynamic that domestic investors alone may struggle to absorb, even if the Ministry of Finance cuts issuance.
As investors sell US assets to repay strengthening yen loans, it pulls liquidity from the US system. If this happens slowly, it could gently deflate inflated stock prices without causing a crash. This orderly withdrawal is preferable to a sudden market rupture caused by bursting bubbles.
