U.S. stocks face a key risk beyond earnings and the economy over the coming weeks, and it's tied to a big move in currency markets that has some investors puzzled as to how and why it's accelerated in the start of September.
Japan's yen, one of the most actively traded currencies in the world, has been on a staggering tear of late, rising nearly 5% against the U.S. dollar over the past month to the highest levels since early February. It was last pegged at around 154.16.
It's a massive reversal for the yen, which had lost nearly half its value against the greenback over the past five years, and traded at a four-decade low of 163.35 in late July.
Its weakness has added substantial pressure to Japan's inflation picture, compounded the government's efforts at debt reduction, and stoked import prices on food and energy just as supply shocks were adding to their overall expense.
But it's also supported the domestic stock market, which is replete with companies that earn the bulk of their revenue and profit in overseas markets. The Nikkei 225 had gained nearly 26% so far this year, and more than doubled since the yen started its long decline in the autumn of 2021.
But the underappreciated risks the yen's fortunes have had on U.S. markets could also be significant.
Japan's long run of near-zero interest rates, used as a tool to buttress its moribund economy, has created fertile ground for the yen carry trade. That's where investors borrow cheap money in Japan, convert the yen to dollars, and put it to work in American markets.
Data from the Bank for International Settlements suggests that trade has deployed somewhere between $1.3 trillion and $1.7 trillion as a result.
But it's now starting to reverse. And fast.
A series of springtime efforts, led by Japan's Ministry of Finance, to buy the yen and support its strength on foreign exchange markets, had little effect.
Then it found some help from U.S. Treasury Secretary Scott Bessent, who was likely concerned that Japan, the world's biggest foreign holder of U.S. Treasuries, might start dumping those bonds to drive the yen higher.
Bessent, already spooked enough by the rise in Treasury yields to authorize a doubling of his department's bond purchases, got involved in a big way.
He sold euros to buy the yen, in concert with another round of intervention from Japanese officials, and hinted that Bank of Japan Gov. Kazuo Ueda should "do the right thing" and raise interest rates later this month.
"I'm not going to tell them what to do," Bessent told Reuters in an interview last week. "I'm going to say that I do think that we probably reached the end of 'Abenomics', which was a reflationary program."
Abenomics, named after former Prime Minister Shinzo Abe, revitalized a stagnant economy with near-zero interest rates and huge government spending.
Current Prime Minister Sanae Takaichi would like to do the same, with a tactic dubbed "Sanaenomics" that's also tied to fiscal expansion and loose monetary policy.
But the implications for the U.S., including an accelerated rise in Treasury yields, and a stronger dollar that blunts the impact of overseas earnings for the biggest S&P 500 companies, is a risk Bessent didn't seem prepared to accept.
But that doesn't mean they've disappeared.
The sudden surge in the yen has given rise to concerns of an unwinding of the carry trade, which would see investors having to sell U.S. stocks to meet the margin calls tied to the yen's recent strength.
In the summer of 2024, which followed a $36 billion government-led intervention to stem the yen's decline, markets moved violently. The Nikkei posted its biggest single-day decline since 1987, while the spillover impact on U.S. stocks saw the S&P 500 fall 6.1% over a three-day period.
Foreign exchange analysts aren't convinced that the yen can sustain its run of gains without further support, either through direct intervention or a Bank of Japan rate hike, but are eyeing a wild card development that could prove crucial.
Japan's Government Pension Investment Fund (GPIF) met in August, conducting its first holiday-season gathering in seven years, raising the specter of a change in investment strategy that would move more of its $2.1 trillion in firepower toward domestic assets.
Mallika Sachdeva of the Deutsche Bank Research Institute argues that even a small shift from current investment bands could bring back $200 billion to Japanese stocks and bond markets, and calls it "the biggest weapon in Japan's external arsenal".
"If the GPIF is mandated to bring a larger share of their assets back into domestic investments, this would be very bullish for the yen," she said. "Equally, if the Bank of Japan is encouraged to accelerate tightening to manage inflation, this too could be bullish".
Both developments, of course, could have big near-term implications for U.S. stocks.
"For equity investors, the key risk is forced deleveraging," said Charu Chanana, chief investment strategist at Saxo Bank in Singapore. "A yen carry unwind can become a broader liquidity shock. Crowded and leveraged positions may be sold quickly as investors repay yen funding."
Liquidity shocks don't always turn into stronger market declines, and the S&P 500 recouped its August 2024 losses reasonably quickly. But the changes in Japan's broader policy, and the impact that's likely to have on U.S. stocks, can't be ignored.
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