In a development that is unsettling investors around the world, yields are soaring in Japan's bond market, threatening to redraw the map of global capital flows amid concerns about a "financial earthquake" hitting the U.S. market.
Yields on 40-year government bonds fell slightly to 3.318% after rising to a record high of 3.689% last week, but remain about 70 basis points higher this year. Yields on 30-year government bonds also rose to 2.914%, while 20-year bonds rose by more than 50 basis points.
Yields started to rise again on Wednesday, with Reuters reporting that demand for 40-year government bonds had fallen to its lowest level since July last year, approaching the record high recorded last week.
According to Macquarie analysts, the sudden rise in yields could trigger Japanese investors to repatriate funds from the U.S. The analysts warn of a "tipping point" that could trigger a wave of global repositioning.
Albert Edwards, chief strategist at Societe Generale, warned that if the trend continues, it could lead to a "global financial apocalypse," and said rising yields and a strong yen will discourage Japanese investors from investing abroad, especially in U.S. stocks, which have attracted huge inflows from Japan in recent years.
An end to the "pregnancy trade"?
The concerns extend beyond bonds. They also extend to so-called "carry trades," a strategy of borrowing in yen at low interest rates to invest in higher-yielding overseas assets. As Japanese yields rise, this trade has come under great pressure.
Edwards noted that investing in the U.S. is more like a currency trade than chasing higher returns than interest rates. In particular, U.S. technology stocks, which see a lot of inflows from Japan, are vulnerable to a strong yen, he said.
Michael Gade, a portfolio manager at Tidal Financial Group, said there could be a repeat of the situation last August, when the Bank of Japan's policy measures led to a strong yen, triggering a sharp selloff in global markets.
David Roche, a strategist at Quantum Strategies, noted that rising yields portend problems for global markets as a whole, as they lead to higher borrowing costs. This risk is amplified because Japan is the world's second-largest creditor nation.
Japan's net external assets will reach a record high of 533.5 trillion yen ($3.7 trillion) in 2024.
"Tight global liquidity will slow global growth to 1%, while rising long-term interest rates will tighten financial conditions and prolong the bear market for most assets," Roach said. He added that capital repatriation to Japan is synonymous with "the end of American exceptionalism" and mirrors movements seen in Europe and China.
The steepening of Japan's yield curve is primarily due to important structural factors, according to Long Len Goh, a portfolio manager on the fixed income team at East Spring Investments. Japanese life insurers, the main source of demand for 30- and 40-year government bonds, are largely meeting regulatory purchase requirements.
A mismatch in supply and demand is likely to push up yields, as the Bank of Japan scaled back its bond purchases last year in a fundamental shift in monetary policy, while private investors have not ramped up their investments.
"If JGB yields spike and Japanese investors return home, we could see a sharp decline in U.S. financial assets as carry trades are unwound," Edwards said. Higher yields tend to lead to stronger currencies.
Carry trades refer to borrowing in low-yielding currencies, such as the Japanese yen, and investing the money in higher-yielding overseas assets.
Yen-denominated transactions began to decline sharply after the Bank of Japan raised interest rates last August, triggering a stronger yen and a selloff in global stock markets.
Japan appears to be on a ticking time bomb, according to Michael Jade, author of the "Developed vs. Developing" report and a portfolio manager at Tidal Financial Group. "If confidence in traditional safe haven assets collapses in financial markets, confidence in global markets could collapse with it," Jade said, adding that people think what happened in August was a "temporary" event.
Jade added that one of the main goals of the current U.S. administration is to lower bond yields and weaken the dollar to address global trade imbalances. If this happens at the same time as Japanese bond yields rise, it will weaken the view of a weaker yen and stimulate yen carry trades.
Despite these warnings, some analysts believe the impact will be gradual rather than catastrophic. The yield gap between Japan and the U.S. has narrowed from 450 basis points to 320 basis points, making selling the yen less attractive.
Masahiko Ro, senior fixed income strategist at State Street, argued that Japan's strategic alliance with Washington makes it unlikely that Japan will abandon its holdings of U.S. Treasuries, noting that most of Japan's investments in the U.S. are concentrated in stocks, not bonds.
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