A significant potential risk is steadily accumulating in Asian markets. As signs emerge that Japan's new Prime Minister is accelerating efforts to consolidate her political base, market concerns are growing that this could trigger a sharp adjustment in yen-related trades and lead to sustained capital outflows from risk assets like U.S. equities. Reports indicate that since taking office as Japan's first female Prime Minister in October last year, Sanae Takaichi is considering calling a snap election as early as February to further strengthen her Liberal Democratic Party's control in parliament. The market widely believes that a favorable election outcome would grant her a stronger political mandate to push for more aggressive fiscal spending policies.
With a stronger political mandate, Japan's budget size for the next fiscal year could expand further. Current market expectations are for an annual budget of approximately 122.3 trillion yen (about $783 billion). This has intensified external concerns over Japan's fiscal deficit and debt financing pressures. Consequently, the yen has continued to weaken this week, dropping to 158.91 against the U.S. dollar, its lowest level since the summer of 2024 and only about 2% away from the historic low of 161.95. The currency has depreciated nearly 13% over the past eight months.
Simultaneously, Japanese Government Bonds (JGBs) have faced significant selling pressure, with yields climbing rapidly. The benchmark 10-year JGB yield closed at around 2.165% on Tuesday, reaching its highest level since the early 1990s, reflecting market expectations for increased government borrowing to fund fiscal expansion.
In stark contrast to the currency and bond markets, Japanese equities have reacted positively to Takaichi's "pro-business" stance. The Nikkei 225 Index has risen nearly 9% since she was elected LDP leader at the end of October last year and hit a fresh all-time high of 53,549 points on Tuesday.
However, the fiscal expansion stance has also created a divergence in policy orientation between the government and the Bank of Japan (BOJ). The BOJ has been steadily and gradually raising interest rates recently to combat inflation that remains above its target level. Adam Turnquist, Chief Technical Strategist at LPL Financial, noted that Takaichi's policy agenda is not aligned with the BOJ's policy tightening direction, putting additional pressure on the yen.
He also warned that the yen is approaching key levels that have historically prompted official intervention. In 2024, when the yen depreciated near the 160 level, Japanese authorities intervened in the market four times. Japan's Finance Minister, Satsuki Katayama, told media this week that she has communicated concerns about the yen's one-sided depreciation with U.S. Treasury Secretary Bessent, who reportedly "expressed understanding of these concerns."
Against this backdrop, the market is beginning to focus on the potential impact on U.S. assets. For a long time, investors have been accustomed to borrowing yen at extremely low cost (short-term rates around 0.7%) and deploying the funds into higher-yielding markets, a strategy known as the "yen carry trade." This very trading pattern has facilitated sustained inflows of Asian capital into risk assets, including U.S. stocks, commodities, and Bitcoin.
However, as Japanese government bond yields rise significantly and the long-term interest rate differential between Japan and the U.S. narrows, the attractiveness of the yen carry trade is diminishing. Should Japan's Ministry of Finance intervene if the yen weakens further, the market could be forced into rapid position covering, potentially triggering concentrated selling of assets in other markets.
In a recent report, Indrani De, Global Head of Investment Research at FTSE Russell, pointed out that the yen carry trade is not a risk-free arbitrage, as investors face currency risk from yen appreciation. Citing data from the Bank for International Settlements, she noted that while the size of this trade is difficult to measure precisely, it is estimated to be between $1.3 trillion and $1.7 trillion.
The market is not without precedent for this risk. In August 2024, a concentrated unwinding of yen carry trades not only triggered the largest single-day drop for Japanese stocks since 1987 but also caused a spike in U.S. market volatility, with the S&P 500 falling 6.1% over three days.
As a result, a growing number of investors are closely monitoring the yen's movements. John Hardy, Head of FX Strategy at Saxo Bank, stated that in the past, Japanese authorities were more focused on the pace of the yen's depreciation rather than a specific level. He suggested it is worth watching closely whether market sentiment would become turbulent if the yen breaches the 160 level with little to no official commentary.
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