Rising Japanese bond yields - the unwinding of the Japanese carry trade:

The Japanese 10 Year government bond has almost doubled from 1.07% last year to 1.95% recently, reflecting the Japanese government’s signal away from deflation and letting interest rates climb higher. The recent (one month) 20 basis point spike in yields signals an 80% chance of the Bank of Japan hiking 25 basis points in their December 19th meeting.

In a somewhat contradictory stance, Prime Minister Takaichi, like her mentor, Shinzo Abe, is also pushing massive fiscal stimulus.

That itself, is worrisome for Japan’s economy, and if bond vigilantes have their way, Japanese bond yields could climb even higher as a sign of less confidence in Japan’s government in managing its finances, similar to what bond vigilantes did to British PM Liz Truss’ ill-fated move to add fiscal stimulus to an already inflationary environment in Sep-Oct 2022. The British gilt market seized up, which led to her resignation, and a new financial phrase “Getting Trussed”. In the US, we almost got “Trussed” around April 7th, when Secretary Bessent had a hard time getting a US treasury auction filled after tariff “Liberation day”.

Back to the current situation, I do see the possibility of some volatility in Japan. Japanese yields are likely to continue moving up unless Japan decides to reduce stimulus, and/or talk down yields. That would be detrimental to the Japanese economy.

In the US I see two problems

The first is the Yen/Dollar carry trade (Borrow at Japanese rates/lend or invest higher at US rates) - which was financed with 0 to 1% Japanese bonds compared to 2 to 4% US yields, for at least two decades. The carry trade financed a lot of the US bond, and equity markets rise and most of the crypto boom.

Now with the Japanese 10 year at a 1.95% yield, and the possibility of more volatility in the treasury market, the carry trade is much more difficult and is unwinding. One of the reasons why the US 10 year has moved in the opposite direction, from 3.99% in late November to 4.16% this morning in spite of a 90% certainty of a Fed Funds rate cut tomorrow is likely because of less Japanese buying or selling of US treasuries - unwinding. (Even as one borrows in Yen and invests in Dollars, the investor has to spend on currency cover to cover the appreciation gain in Yen/ depreciation loss in the US Dollar, and with tighter spreads it becomes even more difficult.)

The second is because of bond vigilantes - who clearly don’t believe that the US should stimulate the economy with 2.75% inflation and only 4.4% unemployment, and have less faith in Kevin Hassett as a Fed chair, and a Fed board that may no longer be independent.

At this time I would think that a fair amount of unwinding has already happened - the biggest unwinding was in August 2024, when the US equity market lost 9% because of the sudden increase in Japanese yield. I also think that there was some unwinding in November when crypto dropped 20% and the Nasdaq Composite 8%.

There is definitely some unwinding risk left in rising Japanese yield, but it may not be the single Dec 19th hike, -- that’s mostly priced in.