high yields spark fears of carry trade unwind

Japan’s bond market is igniting fears of capital flight from the U.S. and a carry trade unwind as long-dated yields hover near record highs.

Yields resumed their move higher Wednesday as demand for 40-year government bonds reportedly dropped to its weakest level since July last year, according to Reuters’ calculations, hovering near record highs hit last week.

Japan’s 40-year government bonds yields hit an all-time high of 3.689% Thursday and were last trading at 3.318% — almost 70 basis points higher so far this year. Yields on 30-year government debt are up more than 60 basis points this year at 2.914%, also not too far from all-time highs, while for 20-year debt they are up over 50 basis points.

Higher Japan government bond yields could spark a wave of capital repatriation with Japanese investors pulling funds from the U.S. There could be a “trigger point” where Japan’s investors suddenly move their capital from the U.S. back home, Macquarie’s analysts said in a note.

Should Japanese government bond yields continue to climb, the move could “trigger a global financial market Armageddon,” said Albert Edwards, global strategist at Societe Generale Corporate & Investment Banking.

Higher yields and stronger yen will impact domestic appetite to invest abroad, he told CNBC. “Investing in the U.S. was as much currency gains as it was seeking superior interest rate returns.” Edwards singled out U.S. tech stocks, which have seen large Japanese inflows, as being particularly susceptible to a stronger yen.

Elevated yields spell trouble for global markets in general as they translate to increased borrowing costs, said David Roche, strategist at Quantum Strategy. Japan being the world’s second-largest creditor raises the stakes even higher. The country’s net external assets hit an all-time high in 2024 at 533.05 trillion yen ($3.7 trillion).

“Tightening global liquidity will reduce world growth to 1% and by raising long term rates it will tighten financial conditions and extend the bear market in most assets,” he said.

This repatriation of funds to Japan is synonymous with the “end of U.S. exceptionalism” and is mirrored elsewhere in Europe & China,” Roche added.

The steepening of Japan’s yield curve is largely due to a key structural factor: Japanese life insurance companies — a key source of demand for 30- and 40-year JGBs — have largely met their regulation-driven buying requirements, said Eastspring Investments’ portfolio manager in the fixed income team, Rong Ren Goh.

With the Bank of Japan scaling back bond purchases in a seminal monetary policy shift last year, and private players not stepping up, the demand-supply mismatch is likely to fuel higher yields.

“If sharply higher JGB yields entice Japanese investors to return home, the unwinding of the carry trade could cause a loud sucking sound in U.S. financial assets,” Edwards said. Higher yields tend to strengthen the currency.

Carry trades involve borrowing in a low-interest-rate currency like the Japanese yen and using those funds to invest in higher-yielding assets abroad. 

Last August, yen-based trades began to unwind sharply after the Bank of Japan raised interest rates, strengthening the Japanese currency and triggering a significant sell-off in global markets.

“Japan looks like a ticking time bomb. If confidence in one of the financial market’s traditionally safe assets has cratered, confidence in the global market could go with it,” said Michael Gayed, author of the Lead-Lag Report and portfolio manager at Tidal Financial Group, adding that people assume what happened in August was a “one-time” occurrence.

Gayed said that one of the current U.S. administration’s primary goals is to lower bond yields and weaken the dollar to address global trade imbalances, and if that happens at the same time Japanese bond yields are rising, it does damage to the cheap yen narrative that fuels the yen carry trade in the first place.

“That could lead to a lot of traders unwinding those short yen positions and then you’re looking at a potential repeat of last August,” he said.

The carry trade unwinding that is about to ensue will be worse than that in August, warned Alicia García-Herrero, chief economist for Asia Pacific at Natixis.

The strengthening yen, driven in part by capital returning home and investors cutting greenback exposure, is unsustainable for Japan’s economy, she added.

The yen has strengthened more than 8% since the start of the year.

Other analysts say the carry trade impact may not be as severe as witnessed last year.

“Big carry positions typically build up when there is a strong FX trend, or very low FX volatility, and [when] there is a big short term interest rate differential,” said Guy Stear, head of developed markets research at Amundi. 

In the second quarter of 2024, the gap between the U.S. 2-year Treasury yield and its Japanese counterpart was 450 basis points, compared to the 320 basis points now, data provided by Amundi showed. 

The advantage in shorting the yen is “less apparent,” he said, adding that a depreciating dollar means there are fewer short yen positions than last year.

While August was “a crater in one go,” what’s going to happen this time will most likely be a steady decline [in the carry trade unwind] because of the erosion in confidence on U.S. dollar, said Riccardo Rebonato, professor of finance at EDHEC Business School.

“Rather than an implosion, I see a progressive erosion over a long period of time,” he told CNBC.

Japan’s large holdings of U.S. Treasuries are structural, anchored in the broader U.S.-Japan strategic alliance encompassing economic, defense, and geopolitical cooperation, said Masahiko Loo, senior fixed income strategist at State Street Global Advisors.

“As such, we see little risk of divestment or ‘dumping’ of foreign bonds by Japanese investors,” Loo said.

Additionally, foreign holdings of U.S. assets are concentrated in U.S. equities, rather than Treasurys, data provided by State Street showed.

A larger chunk of foreign U.S. asset holdings is concentrated in equities at close to $18.5 trillion, followed by U.S. Treasurys at $7.2 trillion, according to Apollo’s chief economist Torsten Slok.

“While we cannot rule out some degree of foreign capital outflows from risky assets in the event of a severe US recession or an intensified “sell America” narrative, we think it likely the outflow will come from equities first with corporate bonds next, and unlikely to start with Treasurys,” Loo added.

Clarification: This story was updated to reflect Reuters’ revised calculations on Japanese bond demand.