USD/JPN Impact On Fixed Income Carry Trades

Japan: Why the BOJ Is Raising Rates

After decades of ultra-loose monetary policy, inflation expectations have risen, wage growth has strengthened, and the BOJ increasingly sees the 2% inflation regime as sustainable. Moreover, JGB yields have risen sharply as the BOJ reduces its bond purchases. This has huge consequences. Japanese bonds are becoming investable again. Japanese insurers, banks and pension funds that historically moved capital abroad because domestic yields were extremely low now have a stronger incentive to hold assets at home.

From JGBs to USTs: Unwinding the Fixed-Income Carry Trade

For years, low Japanese rates supported a simple global fixed-income carry trade: fund cheaply in yen and invest in higher-yielding U.S. assets. BOJ tightening changes that equation. Higher JGB yields reduce the relative return from holding U.S. Treasuries, potentially encouraging Japanese investors to sell or reduce UST positions and repatriate capital. The IMF specifically identifies the U.S. as vulnerable to this portfolio-reallocation channel because of the scale of Japanese holdings. The unwinding of US Treasuries had for impact a step by step re-equilibrium in the change rate USD/JPN. But this is not a good news for the US, as unwinding large positions in UST impacts higher the long maturity yield curves.

Impact on U.S. Life Insurers and the Yield Curve

If Japanese demand for Treasuries declines, the marginal demand for U.S. duration falls. The mechanism is going to be the following, UST selling imply bond prices are going down, with long term yields increasing. Moreover, the term premium is increasing with a potential steeper curve. A potential interesting rade could be to sell 30Y UST and Buy 10Y UST DV01 neutral as we believe the 10s30s is going to steepen even more. The IMF confirms that shocks to JGB yields can transmit into U.S. sovereign yields as it began to happen, particularly through the term premium and Japanese investor exposure. Moreover for carry traders and American life insurers, this creates two effects: For carry traders, higher Japanese rates reduce the yield advantage of holding U.S. Treasuries versus JGBs, weakening the traditional yen-funded carry trade. An unwind of these positions leads to U.S. Treasury selling, putting upward pressure on yields, particularly where Japanese investors have significant duration exposure. 2. For American life insurers, rising long-term U.S. yields initially reduce the market value of their existing long-duration bond portfolios. However, insurers typically hold these assets against long-term liabilities and continually reinvest cash flows.

To conclude, my view is that financial companies around the world but especially in the US have accumulated significant exposure to the historical yen-funded carry trade. As Japanese interest rates normalize, the relative attractiveness of U.S. assets declines, creating an incentive to unwind some of these positions and repatriate capital toward Japan. This could reduce Japanese demand for U.S. Treasuries and put upward pressure on long-term U.S. yields and the term premium. This historical carry trade will affect the American economy in a sense that higher Treasury yields can translate into higher borrowing costs across the U.S. economy. Indeed, mortgage rates, corporate bonds and many consumer and business loans are priced directly or indirectly off Treasury yields. Therefore, a rise in the U.S. term premium caused partly by reduced Japanese demand for Treasuries can tighten financial conditions even without a Federal Reserve rate hike. Raphael Monges