Financial World On Cusp Of Another Liquidity Trap?
In early August 2024, the world’s financial markets were startled — like someone suddenly slamming a door in a quiet room.
Stocks dropped like a rock. S&P 500 for example dropped little over eight percent between August 1st and 5th. Thankfully August 3rd and 4th fell on a weekend, or else panic would’ve caused more damage.
People on TV shouted about the need for emergency rate cuts.
Headlines were frantic.
And the reason? Japan.
It sounds strange that country like Japan could trigger panic in the financial world. But it did, and make no mistake: there are risks brewing, Japan could send shockwaves to the financial world again.
What Happened In Japan?
For many years, Japan kept interest rates very low. That made it cheap to borrow money there. Lots of investors used that cheap money to buy things in other countries — a trade called the Yen carry trade.
But in March and then in July of 2024, the Bank of Japan (BOJ) surprised the financial world by increasing its benchmark rates higher – literally from zero (negative) to 0.1% in March and then to 0.25% by July 2024.
That upset the carry trade and caused a fast sell-off in markets.
The panic was so severe that someone had to say something.
Then a top BOJ official, Deputy Governor Shinichi Uchida, tried to calm things down. He said the BOJ “won’t raise interest rates when financial markets are unstable.” (Source)
That helped calm the nerves of the financial world.
What Is The Yen Carry Trade?
Here’s how the Yen carry trade essentially works:
- Borrow cheap money in Japan (because rates were near zero).
- Change it into another currency, like dollars.
- Buy higher-yielding investments (stocks, bonds, etc.)
It’s easy money if you can do it.
Here’s the thing though: it works well when Japan’s rates stay very low. But when Japan’s rates rise, the carry trade becomes risky. People rush to unwind (close) their trades. That makes markets move fast.
August 2024 was an episode of it.
Japanese Bond Yields Are Surging
Fast-forward to now: Japanese bond yields are rising…very fast.
As I write this, the yield on 10-year Japanese bonds is at 1.88% – the highest level not seen since before the financial crisis of 2008-2009 – up around 80 basis points year-to-date. In 2020, yield on these bonds was NEGATIVE.
The BOJ isn’t holding yields down like it did before. They’re letting them move higher, little by little. And, bonds market is speaking.
And even small changes in Japan can cause big global reactions, because Japan is a key player in world finance.
If yields rise too much:
- Borrowing money in Yen becomes more expensive
- The carry trade becomes risky again
This is why you can’t be ignoring what’s happening with bond yields in Japan.
The Part No One Talks About Enough: Japan Holds a Lot of U.S. Debt
Here’s something many people forget: Japan is the biggest foreign holder of U.S. Treasury bonds. It’s not China.
That means Japan has more than a trillion dollars invested in U.S. government debt.
If Japanese yields rise, investors in Japan might decide they don’t need U.S. bonds anymore — because now they can earn more right at home.
If they start selling U.S. bonds:
- U.S. interest rates would go up
- The U.S. dollar could weaken
- Stocks could get hit
- The global economy could feel tighter and more stressed
This shows how a small change in Japan can ripple around the world.
Bottom Line
I can do a deep dive into this, and where’s the opportunity, but that’s what Trade Ideas is for.
Rising Japanese bond yields is a risk that shouldn’t be overlooked.
We know what happens to financial world when rates in Japan rise, and currently they are rising. Bank of Japan doesn’t really have to do much; bond market is doing the job.
I repeat, August 2024 was an episode. Could we see something bigger now?
Oh and I will leave with some food for thought…
The Japanese Yen has depreciated a lot over years against the U.S. dollar. How low can it go?
Japan is one of the biggest importers of oil globally – could the country afford lower Yen? How does this impact the oil market?