Original author: Long Yue

Original source: Wall Street News

The yield on Japan's 10-year government bonds broke 3% this week, reaching a nearly 30-year high, triggering a chain reaction spreading globally.

The breach of this critical threshold, along with the continued weakening of the yen and rising expectations for interest rate hikes by the Bank of Japan, has amplified concerns about a large-scale unwinding of "yen carry trades." U.S. Treasury Secretary Janet Yellen has publicly warned that if disorderly fluctuations occur in the yen market, it could trigger forced liquidations, further impacting global markets and ultimately raising borrowing costs for American households and businesses.

The market has fully priced in a 25 basis point rate hike by the Bank of Japan in September—this pace is much more aggressive than what the central bank suggested at the beginning of the year.

Why Did the Yield Break 3% at This Time?

The yield on Japan's 10-year government bonds rose above 3% on Tuesday, the first time since September 1996.

This trend is not an isolated event. Global bond markets are generally under pressure, as investors recalibrate inflation expectations and anticipate continued interest rate hikes from major central banks. However, traders and economists believe that Japan's situation deserves particular attention.

The Bank of Japan has ended decades of ultra-loose monetary policy, and the market generally expects its key policy interest rate will continue to rise from the current level of 1%. Meanwhile, the continued weakening of the yen and rising inflation have further intensified pressure on the central bank to accelerate interest rate hikes.

Policy factors are also at play. U.S. Treasury Secretary Janet Yellen has clearly stated that she expects Bank of Japan Governor Kazuo Ueda to raise rates as early as this month. Additionally, Prime Minister Sanae Takaichi's government has openly favored expanding fiscal stimulus, causing investors to express concerns about Japan’s fiscal stability, which is also partly why the yen is weakening and bond yields are rising.

Carry Trades: How Large is the Scale and How High is the Risk?

The logic of "yen carry trades" is simple and straightforward: borrow low-interest yen and invest in high-yield assets.

This strategy thrived while Japan maintained ultra-low interest rates for a long time. Two years ago, when the Bank of Japan raised its policy interest rate to 0.25%, the market experienced significant volatility, attributed to the sudden unwinding of carry trades.

According to the Financial Times, analysts have pointed out that since 2024, the accumulation of carry trade positions has been considerable. Citigroup’s foreign exchange analyst Osamu Takashima noted, “Hedge funds and other short-term investors have been shorting the yen against the dollar while going long high-yield currencies like the Mexican peso.”

Analysts from Capital Economics cited data showing that by early August this year, Japanese residents’ outstanding loans to overseas borrowers had exceeded the peak level of 2024; loans from Tokyo's non-Japanese bank branches to their headquarters also reached the highest level since the global financial crisis.

The latest global fund manager survey from Bank of America indicates that "shorting the yen" remains one of the three most popular trades globally.

However, most analysts believe that the risk of large-scale, sudden unwinding of carry trades is currently still manageable. Goldman Sachs’ chief foreign exchange strategist Kamakshya Trivedi stated that this year’s carry trades funded by yen are more resilient than during the 2024 intervention period, and "structural unwinding" would require Japanese investors to repatriate funds from overseas assets on a large scale. He added, "Currently, there are almost no signs in the official investment portfolio flow data that this rotation has already occurred."

James Lord, head of global foreign exchange strategy at Morgan Stanley, also stated that Japanese investors are still "buying large amounts" of U.S. assets, "We have not yet seen a significant return of Japanese investors to local assets."

U.S. Debt and Global Markets: Japan is the Largest Foreign Holder

Japan is the largest foreign holder of U.S. Treasury bonds, with holdings exceeding $1 trillion, most of which are held by financial institutions.

As domestic yields in Japan rise, the market is concerned that Japan's large pension funds and life insurance companies—these institutions have accumulated hundreds of billions of dollars in paper losses on bond holdings—might adjust their investment strategies and shift funds back from overseas to domestic investments.

Nomura interest rate strategist Naka Matsuzawa stated that Thursday's 30-year government bond auction will be an important signal to observe whether this trend has already begun. “If life insurance companies actively participate in the government bond auction, it could easily lead to market speculation that some funds are flowing back from overseas to Japanese assets.”

Takashima from Citigroup noted that life insurance companies have been waiting for the 20-year Japanese government bond yield to rise to between 2.5% and 3%, but so far they have not entered the market on a large scale due to concerns that prices may decline further. “If they believe the downside risk has peaked, we may see larger-scale fund movements.”

Bank of Japan: Rate Hike in September Almost Certain, Further Action Possible in October?

The market has fully priced in a 25 basis point rate hike by the Bank of Japan in September, which is much more aggressive than what the central bank hinted at the beginning of the year.

Economists believe that part of the reason for this rate hike by the Bank of Japan is to align with the government’s overall efforts to support the yen.

Notably, some individuals are starting to bet on another rate hike in October. A hawkish member of the Bank of Japan's policy board, Hajime Takata, stated on Wednesday that a 25 basis point hike is "not set in stone" and emphasized that "the environment has changed." Ueda also stated on the same day that the Bank of Japan will discuss interest rate issues at all subsequent meetings.

Nevertheless, the yen remains weak, currently hovering around 160 yen per U.S. dollar. The joint interventions by Japanese and American authorities in July and August greatly boosted the yen, but more than half of the gains have been given back. Analysts attribute the continued weakening of the yen in part to the rising stock market—foreign stock investors usually hedge their exposures by shorting the yen, which forces them to increase short positions when the stock market rises.

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