The normalization of Japanese monetary policy is potentially a large global event that may come as somewhat of a surprise to the American political sector and retail investors after decades of malaise in the Japanese economy.
The recent move higher in yields on Japanese government bonds ahead of the Bank of Japan’s policy decision on Dec. 19 is already affecting the global cost of borrowing and will continue to do so as the BOJ moves rates higher.
For elite global investors this is not a surprise. A trillion-dollar carry trade—borrowing in a low-cost currency to purchase higher-yielding assets in the United States, Europe and emerging markets—has long been part of the global financial landscape.
In recent years, crypto has become part of that carry trade, and is likely to be one casualty as the Bank of Japan pushes rates higher.
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The carry trade plays an important role in the financing of global investments, and it is sensitive to currency volatility and shifts in interest rate expectations caused by central banks.
Expected rate cuts by the Federal Reserve and increases by the Bank of Japan will affect the carry trade as investors reassess the use of the deep pool of Japanese savings to finance speculative activity like purchasing bitcoin or American equities.
Any such sustained decline in U.S. rates and increase in Japanese rates will result in a reversal of capital flows back into Japan.
It happened in August 2024, after the Bank of Japan raised its policy rate. When that increase was combined with a weaker-than-expected jobs report in the U.S. that fueled recession fears, investors unwound their positions in the yen and sent risk assets tumbling.
For now, though, the yen carry trade has held up.
Even as Japanese interest rates have increased this year and U.S. 10-year Treasury yields have moderated, the yen has struggled to strengthen. This dynamic has created an example of a K-shaped distortion in financial markets, in which the better off get better while the worse off lose out.
The yen’s movements in this latest episode are not what would be expected.
When U.S. Treasury bonds are offering a greater return than Japanese government bonds, the dollar normally rises at the expense of the yen as Japanese investors buy dollar-denominated securities.
Conversely, the yen strengthens when the U.S.-Japan interest-rate spread narrows, reducing the attractiveness of U.S. securities.
This pattern was observed from 2000 to 2012.
After 2012, the yield spread between 10-year Treasury bonds and Japanese government bonds increased from 65 to 290 basis points and the yen weakened until 2018.
The yen’s weakening trend returned as the U.S. pandemic recovery took hold in 2021 and the yield spread increased from 145 to nearly 350 basis points because of the increase in safe-haven demand for U.S. securities.
But this year, even as Japan’s rates began to normalize and the spread with Treasuries narrowed from 380 basis points to 220, the yen has not kept up.
We can point to several factors that continue to pressure the yen lower:
- Despite positive signs this year, it remains questionable if sustained growth is possible. Economists surveyed by Bloomberg anticipate GDP growth of less than 1% next year and in 2027.
- The yen is starting from a low point, dragging down Japan’s terms of trade.
- Despite the Bank of Japan finally pushing short-term rates above zero, its policy rate remains a fraction of other developed economies. That implies continued use of the yen at the bottom half of carry trades, which further pressures the yen lower.
- Japan’s history of currency intervention is hard to ignore.
Japan is a wealthy country and can continue along its moderate growth path. What the currency needs, however, is a normal level of interest rates that preclude its use in carry trades.
But one gets the sense that recent weakness in the yen and an absence of home bias in investments among Japanese investors is not sustainable.
Should there be a reversal in yen valuations and capital flows back into Japan, global asset values would be affected.
