The Hidden Risk in Japan That Could Collapse Global Economies

The Hidden Risk in Japan That Could Collapse Global Economies

There is so much about this summer in the macroeconomic contents that is repeating last summer if to an even greater extent. But one of the defining features of summer 2024 was the Japanese carry trade blow up. But if macroeconomic weakness is becoming more clearly defined this year compared to last year, where’s the Japanese? What’s up with the Japanese carry trade? Now, obviously, there hasn’t been the same violent reaction here. We’re more than a week out from the July US payroll report and unlike last year, the markets aren’t captured by the same level of chaos. Part of that stems from last year. The Japanese lightened up their exposures. The carry trading was also trimmed to a large extent four months ago in the chaotic deflation of April. However, that doesn’t mean there isn’t a yensized sword of damicle still dangling over the heads of the global financial marketplace. And there are few signs of stirring if not actual distress. Now because of the size and the scale of Japanese participation in these Euro dollar conduits given how sensitive that participation is to economic weakness and economic risks we need to be aware of what it is Tokyo’s big players might be seeing thinking and even doing. So what’s the scale of risk aversion from the Japanese carry trade reversal? What would be part two or actually part three if we consider in factor what happened in April? What is going on there? And where do we look to find some answers? What is the potential for Japan and its carry trade mechanics and key carry trade mechanics to contribute to another round of financial volatility in the wake of more clearly defined macroeconomic weakness certainly here in the US but also around the rest of the world. That’s the key ingredient through the Euro dollar system. risk aversion driven by macroeconomic fears that are becoming macroeconomic reality. Well, we’ll get our answers from the letters JPY and JGB. Now, taking the yen first, any any serious JPY strength is a potential signal for the carry trading gone backwards. Now, to begin, let’s let’s back up a little bit. We’re talking about a specific set of financial arrangements whereby the biggest Japanese firms redistribute credit throughout the entire world via these Euro dollar channels. That’s the carry trade that we’re talking about. Now, the carry trade you might typically hear in the mainstream is something else something else a little bit different. It’s a it’s a less systemically important matter to the world. And that one outside of investment pools who borrow yen from inside of Japan to reinvest in other higher higher yielding places around the world. It does amount to the same thing redistributing credit via financial structures using leverage. But what we’re talking about is these financial behemoths in Japan who don’t need to borrow yen since they have all they could ever possibly want. Yet they still choose to reinvest all over the planet and do so in size because they have little interest in investing locally. But in this carry trade, the real one, Tokyo’s big boys put up their yen as collateral to swap into dollars and then either invest in higher yielding US dollar assets or they use their euro dollar balances they’ve swapped into to swap again into some other currency, largely the euro, which offers potentially even better risk adjusted returns. Never forget this is always, and I mean always about risk adjusted returns. risk adjusted returns. Once you realize that, the entire world makes a whole lot more sense. As we continue to talk about all comes out, these Japanese carry traders are recirculating dollars all around the world, using the Euro dollar as the true reserve currency, intermediating the needs and the goals of both Japan’s carry traders along with the financial and real economy participants who are on the other side of it and usually on the other side of the planet. So, if Japan’s financials aren’t in the same mood to carry trade as they might have been before, there are going to be sizable global monetary then financial and eventually real economy consequences because of it. Now, what they had been doing up to last summer was reaching for yield. costs of borrowing and swapping in Euro dollars went up and with the Treasury yield curve inverted, the returns on the safest, especially longerdated treasuries just weren’t enough to justify those costs. The Japanese carry had actually turned negative. So, they naturally sought higher yielding assets than strictly investing in government bonds. Now, Japan has been doing this more and more ever since 2017, adding a little bit more risk to their carry trades by buying up a few more corporate debts in the various forms, including something like collateralized loan obligations like CLOS’s or leverage loan products and some other stuff. Basically, adding more risk than treasuries to their portfolios and justifying it by saying the economic climate around the world and especially in the US was very favorable to doing so. I mean Jay Powell said the US economy was strong and resilient. So if there if there was any additional risk in buying and holding holding riskier corporates it wouldn’t be all that much. The additional return was worth the smaller increase in risk. The risk adjusted return therefore positive which justified taking on these riskier positions. But then came summer 2024. Suddenly Powell’s polyianic goldilocks message wasn’t resonating. After all, the US labor market was displaying worrisome signs culminating with that July 2024 jobs report which was released in early August. There was indeed more economic risk in the US. Therefore, the riskadjusted return to holding riskier corporate assets was not positive at all. It might have actually been negative. In other words, more risk and not enough additional return over treasuries to justify all that reaching for yield. As a result, the Japanese panic sold CLOS and other riskier forms of junk assets. Spreads blew out. It triggered a V shock in stocks which rippled throughout global share indexes and prices. But it all came down to that one single factor. J Powell was wrong on the economy. It wasn’t strong and resilient and all the consequences in the monetary system as well as the financial system flowed from it. Now in between last year and this year we’ve had somewhat of a ri wild wild ride in the macroeconomy. There was an artificial high that was created out of some rate cut sentiment last year. Hopes driven driven really high by the presidential election in the US. Then most important was all the tariff frontloading that took place. Real economic activity even if it was done for largely non-economic reasons. It all covered up last summer’s worsening conditions. But the artificial high was really nothing more than a temporary reprieve. Plus, it had pulled forward demand that was going to have to be paid back at some point. Which brings us to the spring and now summer of 2025. By every measure, the US economy is worse off this year than last year. Even Mary Daly, the head of the San Francisco branch of the Fed, last week she admitted in the wake of the July jobs report that as as bad as it was in 2025, which caused the Fed to cut by 50 last September, it is materially worse now, which is incidentally very likely to lead to a repeat from the Fed cutting by 50 basis points. But where’s Japan? In the wake of the more shocking payroll figures from two Fridays ago, there was no global carry trade meltdown. Why not? As I said before, a big reason is the Japanese have been reallocating their portfolios ever since last time in last year. They aren’t as overexposed to US macroeconomic weakness this year as they had been last year. Tokyo learned a lesson in blindly following Fed officials waffling opinions about economic circumstances. Rather than continuing to take them at their word, Japanese firms realize the risks are higher than previously thought and have been working through minimizing the asymmetric possibilities so that something like the carry trade blow up doesn’t happen to them again. But it did and that message was reinforced and then some in April. Deflationary conditions four months ago may not have had the same obvious Japanese tinge, but it was all there the same nonetheless. So, while we focused on the dangers that were created by shadow banks and shadow bank funding, and for good reason, there was also some carry trade madness and meltdown in that blow up, too. So, those firms in Japan who maybe hadn’t de-risked out of CLLOs’s and junk your debt in the wake of last August or hadn’t done enough de-risking, they’ve certainly been doing that the past four months, which by the way includes hedging the hell out of positions they can’t immediately or timely extract themselves from. Yeah, hedging with something like interest rate swaps or forward rate contracts like sulfur futures or something similar to that. So in the wake of the jobs report for July 2025, there was a lot less immediate and harsh reaction because this summer the Japanese are already prepared for J Powell to be big time wrong. And one other factor we have to consider too is the reaching for yield or why they were reaching for yield to begin with. short-term interest rates are coming down and now the Japanese know that short-term interest rates are going to go down a lot more which takes a lot of pressure off of carry trading through less risky assets like US treasuries. I mean, that was the key reason why over the last few years they had been so enthusiastic into reaching for yield. They simply believed J. Powell when he said short-term interest rates were going to be higher for longer. And if they were higher for longer, then Tokyo would have to have higher yielding assets. But as we’re finding out, if Powell was wrong about that part, too, then short-term funding rates would be lower in time. Japan could go back to earning positive carry on lowrisisk treasuries. And in fact, Powell would be wrong about hire for longer because he was wrong about the strong and resilient economy. And the Japanese have realized that and been acting on that for the last year plus. That said, that doesn’t mean Japan is entirely out of the woods here. While they have lightened their load quite a bit, they are still exposed and they are still exposed to a significant shock in terms of having to sell assets that are overleveraged and tightly funded, but also perhaps having to throw on even more more hedges and more inconvenient hedges at the worst possible time. There is still the mechanics of the carry trade reversal inside what we see today. And that brings us back to those threeletter abbreviations, JPY and JGB. As far as Japan’s yen is concerned, you can see the stronger yen exchange value from the middle of January until the middle of April. That was the carry trade reversing right then in that second episode. And it matches the decline in treasury yields. So, Japan was rolling out of the riskier debts, ditching some of that past reach for yield and then reinvesting, sticking some of it with US dollar assets and treasuries, but also taking some of the proceeds and repatriating back to Japan, which is one reason why the yen goes up against the dollar. There was a big spike in the yen starting April 1st from around 150 got it almost all the way down to 140, which is during the thick of the deflationary consequences. Spreads were blowing out. So there was definitely some Japanese flavor to what happened in early April. And by the way, this matches gold surge exactly only with gold having been sold as collateral last resort during a few of the most intense days in early April. Otherwise, gold was up January and kept rising also to April 21st, just like the yen. But since then, both gold and the yen have been mainly sideways. Even as the stock market has been soaring, including stocks in Tokyo, some of them anyway, the yen didn’t retrace much of its early 2025 move. It sank back to 150 again as concerns over the Japanese economy have weakened the yen. But those local concerns are being balanced out by some other factor. Some of that in the short run is just interest rate differences favoring the yen. But there is also the carry trade perception keeping the yen really from moving much at all just like gold or interest rate swap spreads. And that brings us to JGBs. Contrary to all the mainstream shouting about how the Japanese are rejecting government bond supply, JGB yields have actually been very quiet too, just like the Japanese yen. They’ve been almost sideways and for several months, the same sideways several months as we see in gold and swap spreads and all the rest. What most people have been saying is that Japan is in the midst of a bond rejection. That the entire world has had enough of the Japanese debt and is fleeing from these government bonds causing rates to sore. Yields on ultra-long bonds have risen sharply. Sure, I mean that’s happened, but it isn’t government debt rejection. The primary problem is the Bank of Japan, not the government in Japan. BOJ has created an environment where the biggest Japanese holders of JGBs are sitting out the market waiting for the BOJ to finally make up its mind about rate hiking. And they were only sitting out the market previously. Contrary to the mainstream narrative, yields are not skyrocketing in Japan, just like they aren’t in treasuries. The 10-year rate, the 10-year GGB rate, for example, jumped to 1.59% at the end of March. Then it plunged during the global deflation in early April. But since then, it has been largely steady to sideways once it came back up from those April lows. And as of right now, the 10-year rate hasn’t gone any higher than 1.6% and is currently sitting at 1.5%. Now, the longer terms going beyond the 10ens, those like the 20 and 30-year JGBs, they did see their yields jump after April, which is what caused all that mainstream media commotion. But since then, since peaking in the middle of May, they’re basically sideways, too. Why? If the BOJ is still screwing everything up with its rate hiking rhetoric, and it is, why haven’t JGB yields gone higher by a lot more? There has to be some other force counteracting the BOJ holding even the longest dated JGB debt from going higher. In fact, going sideways. And it is risk aversion in Japan related to global macroeconomic factors. The same stuff as the carry trade. And part of that is angst over these carry trade exposures that remain. Another way of hedging locally from problems which might develop out in the Euro dollar channels. So JPY should be falling given the increasingly negative local outlook for the Japanese economy. But it isn’t falling because it’s being balanced out by Japanese carry traders looking around the rest of the world especially to the US macroeconomic risk and saying I’m more riskaverse and we need to be prepared in case it does get worse. They appear to be worried enough about even more trouble even after de-risking to a large extent four and five months ago. Same with JGBs. JGB yields are sideways the past three and four months. Even as the Bank of Japan keeps saying rate hikes, rate hikes, rate hikes. Why? Global factors, macro exposures to US recession risk. All the same worries as last August only amplified that much more this year. In that sense though, what we just got from the US payroll report wasn’t a shock to anyone in Tokyo. The July jobs report was a big one last August because everyone over there was still thinking J. Powell knew what the hell he was talking about. Now they know for sure he doesn’t and have been taking advantage of the last year to do something about it. So the question now is whether they’ve done enough. The results in April suggest maybe not. And while there was another huge round of de-risking before and after April, there are still signs that maybe more should happen, especially if or maybe when we get even more confirmation, this really is only the beginning, an inflection from forgot how to grow to remembering how to really screw up the riskadjusted returns of carry trading. And if that does happen, Japan’s carry trading won’t be the sole source of deflation and disorder like it was last summer, but it would be a key contributor to any further disruptions moving forward. Which is one reason why we’re going to watch those three letters, JPY, and those other three letters, JGB. Even Goldman Sachs is now saying, “Yeah, we kind of get it.” They went and looked at the yield curve and surprise to them, they found out the yield curve looks like it’s pointing towards zero rates. went over that the video link below. As always, thank you very much for joining me. Huge thank you members and subscribers. Till next time, take care.

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The macro situation is worse this summer compared to last summer, so where’s Japan’s carry trade? If the July 2024 jobs report provoked a violent financial backlash, you’d think the July 2025 version would have, too. The fact it didn’t points to several key developments, important warnings from JPY and JGBs.

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