Author: Zhao Ying

The global market is underestimating a potential systemic risk—Japan. As the yen falls to decades-low levels and the domestic attractiveness of Japanese assets rises, the world's largest pension fund is facing policy pressure to significantly repatriate assets back home. Once this process begins, the US stock market, bond market, and dollar may face simultaneous pressure.

Recently, Japanese Prime Minister Sanae Takaichi stated that the government would promote increased investment in domestic financial assets by the Government Pension Investment Fund (GPIF) and other national pension funds, and Finance Minister Suzuki Shunichi has previously signaled similar intentions. Although GPIF has not announced any formal asset allocation adjustments, the market has started to assess the potential impact: if the fund turns some overseas holdings back domestically, US Treasury yields may rise, the dollar may weaken, and risk assets may come under pressure.

The market's pricing of these risks remains relatively calm, but some technical indicators have shown subtle changes, and investors should not be complacent.

$1.8 trillion variable

GPIF manages approximately $1.8 trillion, with domestic and foreign assets each accounting for about half, of which overseas holdings total about $930 billion. In recent years, the fund's holdings of Japanese government bonds have declined from about $770 billion to approximately $515 billion, while foreign bond holdings have risen from about $128 billion to around $470 billion.

This structural change means that even minor asset reallocation could trigger significant volatility in global markets. According to MarketWatch, analyst Michael Kramer noted that if GPIF reallocates some of its overseas assets back domestically, it would directly boost demand for the yen and inject large-scale buying into the Japanese government bond market—beneficial for Japan but implying higher rates and a weaker dollar for the US.

Meanwhile, if significant unwinding of yen-funded carry trades (borrowing low-interest yen and converting to dollars to invest in US assets) occurs, it would further suppress the performance of risk assets.

Yen and Japanese bonds: Domestic asset attractiveness is recovering

The potential reallocation of GPIF is backed by substantial improvements in the fundamentals of domestic Japanese assets. As inflation rises and economic growth recovers, the attractiveness of local investment opportunities has significantly increased. In February of this year, the yield spread between two-year US and Japanese government bonds has narrowed to its lowest level since early 2022.

At the same time, the yen's exchange rate continues to weaken, with the dollar breaking through 163 yen, reaching its highest level since 1986. From a technical analysis standpoint, if the exchange rate rises further, the next resistance will be around 176. According to the Financial Times, Fredrik Repton of Neuberger Berman believes that if GPIF reallocates more funds to domestic assets, it could be a "very elegant solution" to Japan's macro issues, but other domestic financial institutions also need to follow suit, and "this process will take a long time."

The yield on Japanese 10-year government bonds recently touched 2.7%, the highest in 30 years. Deutsche Bank analyst Mallika Sachdeva noted in a recent report that Japanese authorities' policy focus may be shifting from managing the exchange rate to managing yields, which, if true, would further pressure the yen.

The market has not yet priced this in, but signals are emerging

Currently, the global market's reaction to the risk of capital returning to Japan remains relatively restrained. The five-year dollar-yen cross-currency basis swap is recently about negative 30 basis points, the narrowest level since data for this series began in 2021, indicating that the market's demand for hedging against yen appreciation has not yet significantly increased.

However, this indicator itself is a key signal to observe whether the flow of funds is starting to shift. Historical data show that the S&P 500 index and the cross-currency basis swap have exhibited synchronous movements during various periods—whenever hedging demand sharply rises, the US stock market often follows suit declines, as liquidity tightens. Once market expectations for yen appreciation heat up, demand for dollar hedging will also rise, and the tightening liquidity effect will become more pronounced.

The Japanese stock market: Another side beyond risks

It is worth noting that GPIF's potential asset reallocation, while bringing pressure to the US market, also provides a new narrative logic for the Japanese stock market. The Japanese stock market is benefiting from drivers that are starkly different from those in the US market: the concentration of the technology sector in the Topix index is far lower than that of the S&P 500, exposure to artificial intelligence is relatively limited, and valuations are still at a discount of over 20% compared to the S&P 500.

Corporate governance reform is a core catalyst for the Japanese stock market. Dan Rasmussen of Verdad Advisers pointed out that there are still about 1,000 companies in Japan with stock prices below book value, with cross-shareholding making up about 40% of the market value of the cheapest fifth of companies. As cross-shareholdings are gradually unwound, a large amount of historically accumulated profits is expected to be released, having a substantial positive impact on corporate earnings.

However, for overseas investors, the continuously weakening yen is the biggest obstacle—over the past two years, the depreciation of the yen has significantly eroded the real returns for foreign capital in the Japanese stock market. How to handle currency hedging and whether the hedging costs are bearable remains a core issue facing global investors.